Strangles


Strangles are a higher risk strategy involving the simultaneous sale of Puts and Calls on the same underlying, with the same strike price and expiration.  The sale of both options provides a credit into the investor's account and that is the maximum potential return.  An investor utilizes the Strangle because they believe the underlying will remain very range bound, or because there may be a shift from high implied volatility(above historical norms) in the option premium to lower implied volatility(back to historical norms).  Before we look at the risk profile of the trade, let's examine an example of a Strangle.

An investor believes BVF will remain around it's current $20 share price so they decide to implement a Strangle.  The investor decides to sell 10 near-term BVF $20 Calls @ $1 and sells 10 near-term BVF $20 Puts @$1, for a total credit of $2 in option premium.  The investor receives $2,000.00 in the account and is subject to margin requirements.  If BVF remains within the breakevens of $18 on the downside(put strike less total premium received) and $22 on the upside(call strike plus total premium received), the investor will have a profit at expiration.  If BVF moves below or above the breakevens, the investor will sustain a dollar for dollar loss with the underlying price.  On the upside, the loss potential is unlimited. On the downside, the loss is only minimized because the stock cannot trade below zero.  

Protective measures should be utilized by the investor if either of the breakevens is breached.  To minimize losses, the investor could "buy back" the side of the trade that is going against them to reduce risk on that side of the trade.  Or, the investor could "buy back" both sides of the trade to exit it completely.