When it comes to options trading, the strangle is one of the most popular strategies, which involves buying a put and a call option with different strike prices but with the same underlying asset and expiration date. This strategy is often used when traders expect a big move in the price of the underlying asset but are unsure which direction it will go.
The main benefit of the strangle is that it offers a wide range of profit potential. If the underlying asset’s price moves enough in either direction, then both the put and the call option will be in the money, and the trader will make a profit.
The main downside of the strangle is that it also has a wide range of possible losses. If the underlying asset’s price doesn’t move enough in either direction, then both the put and call option will be out-of-the-money, and the trader will lose their entire investment.
It would be best to buy a strangle when you are expecting a big move in the underlying asset price but are not sure which direction it will go. You should only enter this trade if you are comfortable with the potential for a significant loss.
It would be best to sell a strangle when you think the underlying asset’s price is not going to move much before expiration. This trade is best suited for more risk-averse traders looking for a defined risk trade.
What are the risks of using a strangle in options trading?
Limited profit potential
The most significant risk of the strangle is that there is limited profit potential. The most you can make on this trade is the difference between the strike prices of the options minus the premium paid for the options. So, if you buy a strangle for $1 and the underlying asset never moves enough to make either option in the money, then your maximum loss is $1.
Unlimited loss potential
Another risk of the strangle is that there is unlimited loss potential. If the underlying asset’s price moves too much in either direction, then one of the options will be deep in the money while the other option will be deep out-of-the-money, which will result in a significant loss.
One of the challenges of the strangle is that it is subject to time decay, which is the tendency for the value of options to decline as expiration approaches. There is less time for the underlying asset to move enough to make either option in the money.
Another risk of the strangle is that it is sensitive to changes in volatility. If implied volatility decreases, then both options will lose value. It can be problematic if you are long the strangle and are counting on a big move to occur.
If you are trading options close to expiration, you may be assigned early. It is especially true if you are trading options that are deep in the money. When you are assigned, you will be forced to buy or sell the underlying asset at the option’s strike price. If the underlying asset’s price has moved against you, it can result in a loss.
What should you consider before trading strangle?
One of the things you should consider before trading strangle is implied volatility. The strangle is a volatile strategy, and it will be more successful in a market with high implied volatility.
Another thing to consider is theta. It is the amount by which the value of an option declines each day as expiration approaches. Theta decay will eat into your profits if you are long the strangle and can result in a loss if you are short the strangle.
Finally, it would be best to choose strike prices that are appropriate for the underlying asset and your outlook. If you choose strike prices that are too close together, you may not make enough money if the underlying asset moves in your favour. If you choose strike prices that are too far apart, you may lose money if the underlying asset doesn’t move enough.
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