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The Strangle is another option strategy that features the use of options in unison with each other. The Strangle is philosophically identical to its "cousin" the Straddle. However, whereas the Straddle has a single strike as its focal point, the Strangle has its focal point spread out over two strikes.

The effect of the Strangle, as compared to the Straddle, is that it will produce wider break-even points and lower prices. The widening of the break-even points for the Strangle changes the risk-reward scenarios for both the buyer and the seller.

The benefit to the buyer of the Strangle is that it will cost less than a Straddle (thus less money at risk) but, like all risk-reward relationships, the price is reduced due to the higher risk. The buyer's trade-off for lower cost is that there is a higher chance of losing that money because the stock will have to move significantly more than if the buyer had purchased a Straddle.

The benefit to the seller of the Strangle is that the Strangle offers a larger margin of error in terms of the anticipated stock movement. The wider range of the break-even prices allows the stock to have more movement while still allowing the seller to profit. The seller's trade-off for this luxury is price. The seller will not bring in as much premium from the sale of a Strangle as opposed to the sale of a Straddle. Again, the seller of a Strangle has less risk of loss and therefore yields a lower return.

That being said, let's take a close look at the Strangle. The Strangle, like the Straddle, consists of two options. In the Strangle, however, the two options are not at-the-money options of the same strike (Straddle), but out-of-the-money options (both a call and a put) of different strikes.

The Strangle features one position (either long or short) and two options: an out-of-the-money call and an out-of-the-money put.

When you put together a Strangle the construction should be as follows:

• different options (out-of-the-money call and an out-of-the-money put)
• same stock
• same expiration
• one to one ratio

Strangle positions are referred to as "long Strangle" or "short Strangle" depending on whether you purchase the call and the put (long) or sell the call and the put (short).

For example, with the stock trading at $57.50, the long Strangle will be constructed by purchasing both the July 60 call and the July 55 put. Meanwhile, the short Strangle will be constructed by selling both the July 60 call and the July 55 put.

It is important to note that the Strangle is a one to one ratio strategy. For every call that you buy (or sell), you must purchase (or sell) exactly one put to properly construct a Strangle. Below, you'll find a chart showing the proper Strangle constructions.

Strangle Scenarios

The Strangle is a strategy that relies on movements in stock price or movement in implied volatility to establish profit opportunities. The Strangle buyer is looking for the stock to move aggressively in either direction or for the anticipated perception of possible aggressive moves which will bring about an increase in implied volatility.

Sellers of the Strangle will be hoping for the opposite, of course. A lack of stock movement or a perceived lack of movement causing implied volatility to decrease will create profitable scenarios for the Strangle seller.

Strangle Mechanics

As a first step in understanding the Strangle, let's look at how a Strangle works. In our illustration, we will look at the July 60/65 Strangle. We can either buy or sell the Strangle. If we purchase both the July 65 call and the July 60 put simultaneously in a one to one ratio we have a long Strangle. To construct a short Strangle we would sell both the July 65 call and July 60 put simultaneously in a one to one ratio.

Continuing with our illustration, we'll set the price for each of the options. With our imaginary stock trading at $63.50, the July 65 call trades at $2.11 and the July 60 put trades at $1.20. The combination of these two prices accounts for the $3.31 cost of the Strangle.

Now fast forward to expiration and observe what happens to the value of the Strangle at different stock prices at expiration.

As you can see, the Strangles value increases the further the stock moves below the lower strike or above the upper strike. The closer the stock is to the area defined by the inner border between the two strikes, the lower the value of the Strangle at expiration. The chart clearly shows that the more the stock moves away from the inside of the strikes, the higher the Strangle's value becomes.

Conversely, the closer the stock finishes in the area in between the strikes, the lower the value of the Straddle. Owners of Straddles want and need movement while sellers of Straddles need stagnation.

How does this example impact your investment strategy? If you feel a stock is likely to move aggressively in either direction or if you feel that implied volatility is expected to increase possibly due to impending news (such as earnings, FDA approval, etc.), you should look into the purchase of a Strangle.

However, if you feel that a stock is likely to enter a stagnant phase or if you feel that implied volatility is likely to decrease, then the sale of a Strangle could be a very profitable trade for you.

Factors that Affect Strangle Prices

Since the Strangle's profit potential is dependent on its price from purchase time to expiration, the investor should be aware of the factors that affect the Strangle's price.

There are several factors that affect a Strangle's price. The first is, of course, stock price. The stock's price will dictate the value of both components of the Strangle -- the call and the put thus affecting the Strangle price as a whole.

As the stock price moves, the prices of the call and the put will fluctuate via the current deltas of the options and thereby affect the price of the Strangle.

As the stock moves higher, the price of the call will increase while the price of the put will decrease. However, they do not move linearly meaning that as the stock continues higher, the call's value increases progressively more while the put's value decreases progressively less. This non-linear effect is caused by the option's changing delta.

The call delta increases as the stock goes up while the put delta decreases as the stock goes up. This opposing effect continues until finally the call gains value dollar for dollar with the stock (once its delta reaches 100) indefinitely. At the same time, the put value-loss stops because the put now has no value (as put delta approaches 0). Of course, the opposite is true if the stock trades down.

The call will lose value progressively slower until it reaches $0 while the put will gain value at an increasing rate until the delta becomes 100 and then the put will gain dollar for dollar with the stock indefinitely. The effect of stock movement on the dollar value and delta value of the Strangle is seen in the chart below.

Again, we will use the July 60/65 Strangle as an example. The Strangle will be worth $3.31 ($2.11 for the call, $1.20 for the put). For clarification, these prices are not expiration prices. This Strangle has three weeks to go before expiration.

A second factor that affects the pricing of a Strangle is implied volatility. As implied volatility increases, the value of the Strangle increases. As stated, the price of both calls and puts increase as implied volatility increases.

A Strangle will feel an increased effect when volatility increases because the strategy employs two options working together and not against each other. When a strategy uses two options working against each other the effect of implied volatility on the strategy is the difference of its effect on each option.

This is different from a Strangle. With a Strangle, the two options are working together so the effect of implied volatility on each option is added together.

Implied volatility movement affects an individual option to an exact dollar amount as indicated by the option's volatility sensitivity component or Vega. An option with a .05 Vega will increase 5 cents in value for every tick that implied volatility increases and likewise will decrease in value 5 cents for every tick that implied volatility decreases.

Because the Strangle combines a call and a put, the Vega value of the call is added to the Vega value of the put. This means that the Vega of a Straddle is the sum of the Vega of the call plus the Vega of the put.

Look back at our example. If the July 65 call has a .10 Vega and the July 60 put has a .07 Vega then the July 60/65 Strangle will have a 0.17 Vega. This means that for every tick that implied volatility increases, the July 60/65 Strangle will increase $.17 in value.

Conversely, for every tick that volatility decreases, the July 60/65 Strangle will decrease in value. The chart below shows how the Strangle's value changes at different implied volatility levels.

When you study the chart you can see that as implied volatility increases or decreases, the value of the Strangle increases or decreases by the amount of the Strangle's Vega multiplied by the amount of tick change in implied volatility.

Finally, time is another major factor affecting the price of a Strangle. As you have learned from our previous strategies, time takes a toll on all options. Its affect is even more pronounced on this strategy that combines two options for the same time period.

A Strangle will see a much higher rate of decay than a single option will. From previous discussions we should be familiar with the option decay chart and its non-linear curve. As time goes by, the Strangle will decay, day after day, at an ever-increasing rate until expiration Friday at 4:00 p.m. The implication to the buyer and seller should be obvious.

The passage of time decreases the value of the Strangle and thus always favors the seller. Time works against the buyer. The buyer has only until expiration to get either a large stock or implied volatility movement to offset the price paid for the Strangle.

Risks and Rewards

The buyer of the Strangle will have the same risk-reward scenario as a buyer of an individual option. That is, the Strangle buyer will have an unlimited reward and a limited risk. As stated earlier, the further the stock moves away from the strike, the higher the value of the Straddle. This creates an unlimited potential profit for the buyer. On the other hand, a Strangle buyer's risk is fixed and limited to the amount spent to purchase the Strangle.

The risk-reward scenario for the seller of a Strangle is the same risk/reward scenario as a seller of an individual option. That is, the Strangle seller has a limited reward and an unlimited risk.

The seller can only gain what was collected in premium from the sale of the Strangle (limited reward). As far as the risk to the seller, the Strangle value can increase as much as the stock price can go up or down. Since the stock has an infinite upside, in theory, so does the Strangle. This is why the Strangle seller is said to have an unlimited risk.

Break-Even and Maximum Reward and Maximum Risk

When you are contemplating your possibility for profit with a particular Strangle, you must establish your break-even point. The Strangle is unique in that it has two break-even points. It is important to calculate both to determine how much the stock must move (either up or down) to close at a price that is profitable for the buyer/seller of the Strangle.

Break-even is defined as the stock price, at expiration, where the position neither makes nor loses money. Because the Strangle involves both a call and a put, the position can make money with a stock movement in either direction, up or down.

Therefore, a Strangle will have two breakevens. One will be at a stock price above the higher strike of the Strangle, the other at a stock price below the lower strike of the Strangle.

In order to calculate the break-even for a Strangle, you take the strike price of the call and then add the total price of the Strangle to it to determine the upper break even price. To determine the lower break-even price, subtract the total price of the Strangle from the strike price of the put.

Let's look at an example.

We'll use the May 55/60 Strangle trading at $3.00 with the stock price directly at $57.50. For simplicity, let's assign a price of $1.50 for the May 60 calls and $1.50 for the May 55 puts. As defined by the formula, in order to calculate the downside break-even of the Strangle, we take the put's strike price ($55) and subtract the Strangles total price ($3.00) and we get a price of $52.00 as our downside break-even.

Let's see how this works. At expiration, with the stock at $52.00, the May 55 put will be worth $3.00, a net gain of $1.50. Meanwhile, the May 60 call will be worthless, incurring a net loss of $1.50. The loss in the call was offset exactly by the gain in the put. So, at expiration, the Strangle is still worth $3.00 (May 60 call $0 plus May 55 put $3.00).

As for the upside break-even, we take the call's strike price (60) and add to it the total price of the Strangle ($3.00) and we get $63.00 as our upside break-even. This checks out because at expiration, with the stock at $63.00, the May 55 puts will be worthless, losing $1.50.

Meanwhile, the May 60 call will be worth $3.00, gaining $1.50 which offsets the put loss exactly. The Strangle started out worth $3.00 ($1.50 May 60 call and $1.50 May 55 put) and with the stock at $63.00 at expiration, the Strangle will still be worth $3.00 (May 60 call $3.00, May 55 put $0).

The importance of calculating the break-evens is to determine where the stock has to close at expiration to profit the buyer or seller of the Strangle. We can easily find the ranges where the long and short Strangle holders will profit.

The buyer of the Strangle profits at expiration when the stock closes outside the break-even prices while the seller profits when the stock closes inside the break-even prices.

Using our previous example of the May 55/60 Strangle and our two break-even prices of $52.00 to the downside and $63.00 to the upside, the chart below shows a range of possible stock closing prices at expiration and the profit/loss associated with those prices for the buyer of the Strangle.

* Break-even prices are marked with an asterisk.

Notice that the buyer's profit starts at the first price outside of the break-even range and increases dollar for dollar with the stock as the stock continues to move away from the higher and lower strikes respectively.

Also notice that the buyer's loss is at its maximum when the stock closes directly in the middle of the two strikes. Of course, the buyer can sell out of the Strangle at any time prior to expiration if they felt the Straddle was priced at a level they deemed worthy of a sale for either profit or for a minimizing of loss.

An investor never has to hold a position all the way to expiration if they do not want to. A profit can be taken at any time during a positions life. Like wise, a loss can be taken at any time during the life of a position in order to minimize a future larger loss. Positions do not need to be held until expiration. This is normally more important to buyers of option positions as opposed to sellers of option positions because buyers of premium are hurt by the passage of time while sellers are aided by it.

For a buyer of a Strangle, time decay starts to erode the Strangles price immediately. Time decay does not sleep and increases progressively over the course of the position. The buyer is faced with a large premium decay because the Strangle features the owning of not one, but two options hence double the decay.

With decay working against the long Strangle, the buyer is best served taking profits a little more quickly or at least being much more diligent in monitoring the position and reacting quickly to changing prices.

If the Strangle was purchased in front of an expected news release (like most Strangles are) that could move the stock dramatically, a Strangle buyer is advised to be ready to take profit or limit losses shortly after the news is out. Further delay will cost time decay dollars and will probably be worsened by a decrease in implied volatility now that the news event is over.

The seller of the Strangle has a potential profit when the stock closes inside of the range formed by the two breakeven prices. Again, using our May 55/60 Strangle example, and our two breakeven prices of $52.00 and $63.00, the chart below shows a range of possible stock closing prices at expiration and the profit/loss associated with those prices for the seller of the Strangle. The breakeven prices are marked with an asterisk.

Notice that the seller's profit starts at the first price inside the range of stock prices defined by the breakeven prices and increases as you move to the middle of the strike prices (call and put) of the Strangle from both break-even prices.

The maximum profit of the Strangle for the seller is obtained when the stock closes exactly in the middle of the strike prices at expiration.

Outside the range of the breakeven prices, the Straddle loses money for the seller at a dollar for dollar pace with the movement of the stock away from the break-even range in either direction. Of course, the seller does not have to carry the position all the way to expiration.

At any time prior to expiration, the position may be bought back when it is deemed prudent by the seller. Normally, however, the longer the seller waits to take the position off, the better. The passage of time works in favor of the seller. As more time goes by without a stock or implied volatility movement, the bigger the profit grows for the seller.

Remember, however, the seller's profit is always limited to the total price received for the sale of the Strangle.

For the seller, time decay is welcome. The more time that goes by with stagnation, the lower the Strangle's value becomes thus the more profit to be had. Sellers of Strangles need to be patient and to allow time to do its thing. However, that being said, a Strangle seller does not have to wait until expiration either.

The Straddle does not have to go to $0 in order for the seller to make money. If the Straddle loses value quickly as in the case of a decrease in implied volatility, there may be a big enough profit in the trade to warrant the seller to lock in the profit before expiration. There is nothing wrong with taking profits and eliminating risk at the same time. That is how money is made and kept.

Conclusion

In conclusion, the Strangle in an ideal strategy for playing large stock movements, movements in implied volatility and time decay. It is constructed by the purchase or sale of an out-of-the-money call and an out-of-the-money put in the same stock and the same month. The buyer has an unlimited profit potential and a limited loss scenario.

The seller has a limited profit potential and an unlimited loss scenario. The price of a Strangle can be influenced by stock price, implied volatility and time decay. It is a position which requires large stock or volatility movements for the buyer and of course, a lack of movement for the seller.

As always, the Strangle should only be executed after the investor completes their due diligence research on the stock, formulated an opinion, then weighed the strategies available and chose the Strangle as the safest and most efficient way to profit from their conclusion of the stock's future movement.