Trading The Long Strangle Spread

One option spread strategy that’s often overlooked by traders is the long strangle. This spread involves the purchase of a call and a put that are both out of the money; on the same underlying stock or ETF and the same expiration date.

The long strangle has unlimited profit potential, while the risk is limited to the purchase price that was paid for both options, making it the ideal strategy for options traders who prefer strategies with limited risk and unlimited profit potential.

The best time to initiate the long strangle is during periods when volatility levels are expected to increase significantly over the near term. Therefore it’s very important to check the implied volatility level on the underlying stock or ETF and make sure that the current level is on the lower end of the range.

As a general rule, whenever initiating any type of position that involves a debit, whether net positions or spreads, the spread should only be initiated when implied volatility levels are in the lower end of the range.

In the example below, you can see the SPY ETF over a period of 11 months. Notice how implied volatility level were fairly low; moving between the 0.10 and .20 for the majority of the time, then sharply rising to the 0.40 level. The best time to initiate the long strangle in this case would be when  implied volatility was closer to 0.10 and offset or close the position when implied volatility was close to the 0.40 level.

strangle

One of the biggest mistakes that beginners often make is not taking implied volatility into account and focusing strictly on the technical price action or market sentiment. Implied volatility can cause the price of the options to increase dramatically, even when the underlying asset is barely moving.

The great majority of the time, long strangles are initiated when the trader believes that a strong price move is on the way; usually prior to earnings or important news announcement, when the odds of a major price move is very strong, but directional bias is uncertain.

Because the day that the news or earnings are coming out is known by the general public ahead of time, implied volatility levels rise in anticipation of these events. And by the time the options are purchased, implied volatility levels have already “priced in” the potential price move, thereby strongly decreasing the potential gain in the price of the option substantially. This is another reason why it’s crucial to check implied volatility level to make sure that when you purchase the long strangle, implied volatility levels are in the lower end of the range, and are only beginning to rise.

Another major factor to consider is the strike price of the both options in relationship to the underlying asset.

Profiting from long strangles involves a major increase in the price of one or both of the options that you purchased. Realistically, the profit will come from one of the options, so you have to make sure to select options that give you the highest degree of movement, in relationship the smallest price move in the underlying asset.

One common mistake that beginners tend to make is focusing on the strike price of the option, instead of the Delta. The actual strike price doesn’t tell you very much, unless the option is deep in the money, otherwise your Delta can vary greatly; resulting in a price move that is different than expected when the trade was initiated.

In a nutshell, you need to pick options that have a high Delta, this will help you find options that have very high sensitivity to the underlying stocks price movement and will ensure that when the underlying asset increases in price in either direction, the options that was purchased will increase substantially in value.

The Delta ranges between 0 and 1.00 for calls and 0 and -1.00 for puts. A call buyer and put seller is positive Delta, while the Put buyer and Call seller are negative Delta.

To give you a very simple example, if an option has a Delta of positive .60, the trader can realistically anticipate the price of the option to increase $0.60 for every dollar increase in the price of the underlying stock. If the option has negative Delta, the same stock would lose $0.60, for every dollar the stock would increase in value.

As a general rule, my preference for long strangles is to select Calls and Puts that have a Delta ranging from .65 to .85. I find that I can still stay slightly out of the money, while gaining substantially if the underlying asset undergoes strong price move in either direction.

Once the Delta moves below .65, the movement in the underlying asset must be very strong to make up for the lower sensitivity of the Delta. Therefore, it’s best to purchase options with higher Delta, unless the move that’s expected in the underlying asset is substantial.

In summary, always check the Delta before initiating directional options trades. If the Delta is low, the underlying asset will have to move substantially for the option to gain any real value. If on the other hand the Delta is high, the option will gain substantially in relationship to the underlying asset, since the sensitivity to of the option to the movement of the underlying asset will be high.

Lastly, don’t forget that buying long strangles before earnings or other major news, may not be the best idea, since implied volatility will “price in” the potential price move into the price of the option ahead of time; limiting your profit opportunity greatly. Therefore, always check implied volatility, in addition to Delta, when trading long strangles, since both Greeks can have a major impact on the price of the spread, as well as the price movement of each option, if the underlying asset generates directional momentum.

All the best,

Roger Scott
Head Trader
Options Geeks