A Strangle is a slight modification of the Straddle, making it cheaper to execute. This strategy involves the simultaneous buying of a slightly out-of-the-money (OTM) Put and a slightly out-of-the-money (OTM) Call of the same underlying stock/index and expiration date.
[OTM Put - When the put option's strike price is lower than the prevailing market price of the underlying stock.
OTM Call - When the call option's strike price is higher than the prevailing market price of the underlying stock.]
Here again, the investor is directionally neutral but seeks increased volatility in the stock/index, with prices moving significantly in either direction. Since OTM options are purchased for both Calls and Puts, the cost of executing a Strangle is lower compared to a Straddle, where ATM strikes are generally purchased. Since the initial cost of a Strangle is lower than that of a Straddle, the potential returns could be higher. However, for a Strangle to be profitable, the stock/index must move more significantly in either direction than it would for a Straddle. As with a Straddle, the strategy has a limited downside (i.e., the Call and the Put premium) and unlimited upside potential.
When to Use: The investor thinks that the underlying stock/index will experience very high levels of volatility in the near term.
Risk: Limited to the initial premium paid.
Reward: Unlimited
Breakeven:
Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid