Straddles And Strangles
Last week I explained how a day trader could purchase catastrophe protection at a reasonable cost by buying a deep out-of-the-money (OOTM) call and a deep OOTM put with several months left to expiration. This position, held until expiration, will almost certainly expire worthless, suffering complete time decay. The cost of the position is the cost of the call plus the cost of the put and, amortized over the several months of trading days to expiration, may represent a modest daily insurance cost for an active day trader.
A position consisting of one long OOTM call and one long OOTM put with the same expiration is called a strangle. It differs from a straddle in that the strike prices of the two options are not the same, as they are in the straddle, but it is like the straddle in that it consists of a put and a call with the same expiration.
A strangle can be a trading position. Long strangles behave like long straddles, in that they benefit from high volatility, while short strangles benefit from low volatility, as do short straddles. If you purchase a long strangle as insurance, you should consult the fair value of each option and buy at prices as discounted as possible from the theoretical value.
Selling a strangle consisting of an overpriced call and an overpriced put may seem like an attractive trade. If you sell a strangle, your chances of collecting the premium without penalty are high; but if the underlying closes outside the range of the two strikes you have chosen, what may be high is the penalty you suffer. Alternately, if you purchase a strangle, your chances of profiting are low; but if you do profit, your profit can be very high.
Overpriced strangles can be tempting shorts, since you are almost certain to make a profit. But they have precisely the same characteristics as a naked short, which can be very hazardous (and they have these characteristics times two).
Unless you are very skilled in trading your way out of dicey positions, I would recommend that you avoid strangles, either long or short. If you are a successful day trader (in which case you probably have this skill anyway), the strangle represents an insurance policy that you may want to take.