If strangle traders can make money regardless of market direction, doesn’t it provide the best odds of success? (part 1 of 3)
The term strangle is somewhat ambiguous in that it can be applied to long options, short options, and even futures strategies. Accordingly, I feel like this question is best answered by addressing all three approaches. In order to do the topic justice, we’ll need to extend this question to the February and March columns making this column part one of a three part series.
We’ll start with the strategy of buying option strangles. This simply includes the simultaneous purchase of both a call and a put option with out-of-the-money strike prices. If you are not familiar with options, a call option is the right to buy the underlying futures contract at a specific date and time in the future at a specific price (referred to as the strike price). A put option is simply the right to sell a futures contract at the strike price of the option at a specified point in the future. Buying a call is a bullish proposition, but buying a put is bearish. Therefore, the purchase of both creates a neutral strategy anticipating a large move in one direction, or the other.
Naturally, owning the right to buy or sell the underlying futures contract at a specified price in the future comes at a cost. Buyers of these options must pay a premium to the sellers to acquire the right. This is the same concept the insurance industry operates on; the insured pay a premium to the insurer for the right to benefits should a certain event occur in the future. Most of the time, however, an event that triggers a claim does not occur and the policy seller (the insurance company), keeps the premium.
Now that you have a basic understanding of options, let’s take a closer look at a long strangle strategy in the futures markets. Strangle buyers have the freedom to choose the strike prices of their long call and long put options. Because the right to buy or sell the underlying futures is more valuable if the strike price is closer to the current price, the closer the strike prices are to each other the more expensive the strangle will be to buy. Some of you might be thinking that this doesn’t matter because the trade stands to make money regardless of whether prices go up or down. Nonetheless, the cost of the strangle is very important to the trader because it defines his overall risk but, perhaps more importantly, becomes the hurdle to turning a profit on the trade.