This approach is profitable if the stock price makes a significant shift in either direction during the option's term.
Typically, this technique comprises the purchase of an out-of-the-money call option and an out-of-the-money put option with the same expiry date.
The investor is anticipating a significant change in the underlying stock, either up or down, throughout the option's term.
This method performs best when the stock price makes a dramatic swing in either direction during the option's life.
The technique is designed to profit from a sharp rise in implied volatility or a significant shift in the underlying stock price throughout the option's term.
- Long 1 AAPL 165 call
- Long 1 AAPL 155 put
LOSSES ARE LIMITED TO THE MAXIMUM
Premiums paid in full
In contrast to a straddle, this approach has the call strike above the put strike.
Both the call and the put are, by definition, out-of-the-money.
Strangles are less expensive than straddles, but they often require a higher move in the underlying stock to breakeven.
The gut is another variation on this technique, in which the call strike is lower than the put strike.
Due to the fact that both the call and put strike prices of a gut are often in the money, at least one of them must be, this approach is extremely costly and hence rarely employed.
Maximum loss is capped.
If the underlying stock remains between the strike prices until expiration, the maximum loss happens.
If the stock's price is between the strikes at expiration, both options will expire worthless, resulting in the loss of the whole premium paid.
Gains are limitless.
The greatest gain happens when the underlying stock reaches infinity, while a significant gain occurs when the underlying stock becomes worthless.
At expiry, the gross profit would be the difference between the stock's price and either the call strike price or the put strike price, depending on which is higher.
The net profit is calculated by subtracting the gross profit from the premium paid for the options.
The upward potential is limitless, and the downside potential is limited only by the fact that the stock price cannot go below zero.
Profitability is limitless on the upside and rather big on the downside.
The loss is limited to the option price paid.
This approach is profitable if, at expiration, the stock price is either above or below the call strike price by the premium paid.
At either of those levels, the intrinsic value of one option will match the premium paid for both options, while the other will expire worthless.
Breakeven point on the upside equals call strike plus premiums paid
Breakeven on the downside = put strike - premiums paid
Increased implied volatility, all other factors being equal, would be tremendously beneficial to this approach.
Even if the stock price remains stable, a sharp increase in implied volatility would increase the value of both options, allowing the investor to profitably exit the position well before expiration.
Time, on the other hand, will have a significant detrimental effect on this technique.
Because the technique entails holding two options, each day that passes without a change in the underlying stock's price results in a considerable loss of their value.
The investor retains complete control.
Risk of Expiration
If the options be kept until they expire, one of them may be exercised automatically.
This technique is essentially a race against the passage of time and volatility.
The passage of time is a constant that gradually erodes the position's worth.
Volatility is the storm that can strike at any time or never materialize at all.