Options can be confusing at times but they are typically contracts between a buyer and seller concerning an underlying investment, such as stocks (but this is not always the case as other investment vehicles may be used as well). The contract gives the buyer of the option the right to buy or sell a 100-share block of stock at a given strike price, before an expiration date, for a premium. However, owning an option for an underlying stock does not obligate the investor to buy or sell the stock – but it does ensure them the right to do so if they so choose.
There are several different types of options but the two most common varieties are “call” and “put” options. Call options are purchased when investors believe the market value of the stock will rise before the expiration date. Put options, on the other hand, are purchased because it is believed that the underlying value of the stock will decrease. Investors who use the “buy strangle” option investment strategy are opting to hedge their investment risk by purchasing both call and put options for the same underlying stock.
Investors using the “buy strangle” option investment strategy will buy a put option with a set strike price (strike price 1). The investor will also buy a call option for the same underlying stock – but with a higher strike price (strike price 2). It is similar to the “buy straddle” investment strategy, where the investor purchases put and call options for the same underlying stock, but at the same strike price, however the buy strangle tactic has a greater potential for profits. The higher the strike price of an option, the riskier the investment, and consequently, the lower the premium charged for buying the option. Of course this lower premium will be offset by a higher premium charged for the low strike option.
The buy strangle option investment strategy is recommended for use when investors believe the price of stock will rise above – or below – a given price range. Corporations and investment companies typical offer earnings forecasts, and the ability of companies to meet these earnings predictions plays a large role in the price movements of the stock. Investors who believe that prices will be significantly higher or lower than the predicted range (perhaps due to an earnings surprise) will be more inclined to use the buy strangle option investment strategy.
The potential for profit using the “buy strangle” strategy is unlimited. Profits increase the higher the stock price settles above the strike price of the call option, or the lower it settles below the put option strike price.
The break-even point for the put option will be the exercise price minus the price paid for both options. The break-even point for the call option will be the exercise price, plus the price paid for both options. However, total loss is limited to the amount paid for both options. For every point the stock price settles above the call option strike price, or below the put option strike price, the total loss decreases by one point (until the break-even point is reached).