A Strangle is a slight modification to the Straddle to make it cheaper to execute. This strategy involves the simultaneous buying of a slightly out-of-the-money (OTM) Put and a slightly out-of-the-money (OTM) Call of the same underlying stock/index and expiration date.
[OTM Put - When the put option's strike price is lower than the prevailing market price of the underlying stock.
OTM Call - When the call option's strike price is higher than the prevailing market price of the underlying stock.]
Here again, the investor is directional neutral but is looking for increased volatility in the stock/index and the prices moving significantly in either direction. Since OTM options are purchased for both Calls and Puts it makes the cost of executing a Strangle cheaper as compared to a Straddle, where generally ATM strikes are purchased. Since the initial cost of a Strangle is cheaper than a Straddle, the returns could potentially be higher. However, for a Strangle to make money, it would require greater movement on the upside or downside for the stock/index than it would for a Straddle. As with a Straddle, the strategy has a limited downside (i.e. the Call and the Put premium) and unlimited upside potential.
When to Use: The investor thinks that the underlying stock/index will experience very high levels of volatility in the near term.
Risk: Limited to the initial premium paid.
Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid