Strangles and Guts  Option Strategy

Buying a strangle consists of the simultaneous purchase of a higher strike call and a lower strike put with the same expiration but different strikes. An example of purchasing a strangle is buying the July 105 call for $3 and buying the July 95 put for $3.

The following scenarios may develop at expiration:

1. If the future is above 105 the call will be in the money and the position will be long one future at 105. Since the total outlay of cash is $6 ($3 + $3) the position will become profitable above 111.

2. If the future is between 95 and 105 the call and put will expire worthless, and a loss of $6 will be incurred which is the price paid for the strangle.

3. If the future is below 95 the put will be in the money and the position will be short one future at 95. The position will become profitable below 89.

A strangle is somewhat similar to a straddle in that the purchaser expects the market to make a large move in one direction or the other. The cash outlay is less for a strangle than a straddle if the straddle is between the 2 strikes of the strangle. For example, the 95 put and 105 call strangle should always be cheaper than the 100 straddle with the same expiration, no matter where the future is trading. This occurs because the straddle will always yield more potential reward than the strangle. The straddle will always have more intrinsic value, except when the future is at 100. If the future closes at 105 on expiration, the straddle will be worth $5 but the strangle will be worthless. The future must move a greater amount for a strangle than a straddle to become profitable.

The sale of a strangle is the simultaneous sale of a higher strike call and lower strike put with the same expiration but different strikes. The sale of the August 105 call for $3 and the August 95 put for $3 is an example of selling a strangle. Figure 15.4 shows the profit and loss potential in the present and at expiration of selling a strangle. In this case the investor will profit if the market is between 89 and 111 at expiration. Below 89 the position is similar to being long the future at 89 and above 111 the position is similar to being short the future at 111. The strategy for selling a strangle is similar to selling a straddle because in both scenarios the investor believes the market will remain within a relatively narrow, or well defined, trading range.

The purchase of a gut is the simultaneous purchase of a lower strike call and a higher strike put, such as the August 95 call and August 105 put. The sale of a gut is the simultaneous sale of a lower strike call and higher strike put. A gut has similar profit and loss characteristics as a strangle, but the trader may need to be concerned about early exercise with a gut because both options may be in the money at the same time.