With option trading a strangle is an investment strategy involving the purchase or sale of a particular option derivative that allows the holder to profit based on how much the price of the underlying security moves, with relatively minimal exposure to the direction of price movement. The strategy involves buying an out-of-the-money call and an out-of-the-money put option.
As an example I will trade PowerShares DB US Dollar Bullish Fund UUP, a stock currently trading at $22.97 a share. Below is a calendar of UUP options expiring January 18, 2013.
UUP 22.97 0.16(0.70%)
To employ the strangle option strategy a trader enters into two option positions, one call and one put. The trader wants to purchase 100 contracts (1 contract = 100 shares) for a call position and 100 contracts for a put position. Say the call is for a $24 strike price and costs $2,100 ($.21 per option contract x 100 shares x 100 contracts) and the put is for a $22 strike price and costs $2,000 ($.20 per option x 100 shares x 100 contracts). If the price of the stock underlying stays between $22 and $24 over the life of the option the loss to the trader will be $4,100 (total cost of the two option contracts). The trader will make money if the price of the underlying starts to move outside of the range. Say that the price of the stock ends up at $25. The put option will expire worthless and the loss will be $2,000 to the trader. The call option however has gained considerable value. The value of 100 contracts of an in-the-money expired call option would be worth $10,000 ($1.00 per option x 100 shares x 100 contracts). So the total gain the trader has made, minus $2,000 loss, is $8,000.
*A trader can sell the underlying, in this case UUP, at anytime. He or she does not have to hold an option through the expiration date.