Option strangles and iron condors: Targeting movement but not direction

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Combining options to spread out risk and reward.

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Traders who are starting out in options tend to focus on directional plays. For example, a beginner might buy a call option because they think a stock, exchange-traded fund (ETF), or other security is going higher, or buy a put option if they think it’s going lower. Or they might prefer to collect premium up front. (If they’re comfortable with the open-ended risk of short options, a bullish-biased trader might sell a put and one with a bearish bias might sell a call.) 

But advanced traders know that sometimes the play is about the magnitude of price moves (or volatility), but not a particular direction. And that’s when they look to the option strangle (and its single-strike cousin, the straddle) to hit their objectives. Expecting a big move one way or the other? Buy a strangle. Think the market is pricing in too big of a move? Sell a strangle.

But before you do anything, get comfortable with the risks. Because every option strategy requires an up-front assessment of the risks and potential profit.

A strangle is the simultaneous purchase (or sale) of a call and a put option with the same expiration date but different strike prices. Typically, both strikes are out of the money when the trade is initiated, meaning the call strike is higher than the prevailing stock price and the put strike is lower than the prevailing stock price. If you initiate the trade by buying the call and put, it’s a long strangle. If you lead with the sale of the call and put, it’s a short strangle.

Consider the following option chain. Assume the underlying stock is trading at $205 per share and that there are 30 days left until expiration.

Looking at the 200 and 210 strikes (with the 200 put and the 210 call being the out-of-the money options):

See figures 1 and 2 for graphs of long and short strangle risks, then keep reading for a deeper explanation.

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Figure 1: LONG STRANGLE RISK AND REWARD. With a long strangle, you pay a premium up front, and that’s the most you can lose. For educational purposes only.

Encyclopædia Britannica, Inc.

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Figure 2: SHORT STRANGLE RISK AND REWARD. When you sell a strangle, you collect a premium, but as the stock price deviates from the strike price, your profit erodes until it becomes a loss—perhaps a substantial one. For educational purposes only.

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When assessing the risks and rewards of an option strategy, it’s best to start with the payoff at expiration. In each case, the flat, horizontal section is the difference between the two strike prices. To understand why, you need to know the difference between intrinsic value (the amount by which an option is in the money) and extrinsic value (the value of uncertainty, that is, time and volatility).

At expiration, there is no extrinsic value, so any value in the position is intrinsic. In figure 1, the extrinsic value is the difference between the pink and blue lines. Note that the distance is widest at each of the two strikes that make up the strangle.

Following the example above, suppose you paid $5.25 for the 200/210 strangle and that on expiration day, the stock settled at exactly $205. Both the call and the put would expire worthless, and you’d be out the entire premium. The same can be said for an expiration-day settlement at $202, $209, or even $200.01. For any expiration-day settlement between the two strikes, the long strangle experienced its maximum loss—the entire premium.

Now let’s say instead that the stock settled at $218. In that case, the put option would expire worthless, but the call option would have (218 – 205) = $13 of intrinsic value. Subtract the $5.25 you paid for the strangle, and your profit on the trade would come to ($13 – $5.25) = $7.75 (that’s $775 with the multiplier).

For a long strangle, the breakeven points would be the strike price plus or minus the total premium, or 200 – 5.25 = $194.75 on the downside and 210 + 5.25 = $215.25 on the upside. If the stock is above or below one of those breakeven points at expiration, it’s a profitable trade. If not, the position loses money. On the upside, your profit is theoretically infinite. To the downside, it’s technically limited—the stock could fall to zero, but no lower. Those are your risk and profit parameters.

Applying the same logic to the short strangle, with the stock between $200 and $210 at expiration, you would pocket the entire $5.25 in premium, because neither the call nor the put would be exercised. Your breakeven points would be exactly the same—$194.75 and $215.25—but any settlement in the stock price beyond one of those points would turn this position into a losing trade.

Your losses from a short strangle could be staggering—theoretically infinite if the stock were to stage a massive rally. (For reference, recall the meme stock craze of 2021.) And if the stock were to suddenly become worthless (unlikely, but not impossible), one 100-share option contract could cost you (100 x 194.75) = $19,475. 

For this reason, most brokerage platforms have restrictions on selling options. You would either be required to have a lot of capital in a margin account, or you would be required to hedge your short options with long options and/or place stop-loss orders in case the stock were to rise or fall substantially.

The biggest drawback of a short strangle is the risk of unlimited losses if the underlying stock makes an outsize move. That’s why many traders will buy a second strangle at strikes wider than the short strangle. This four-legged spread is called an iron condor, and it will turn the open-ended risk of a short strangle into a defined-risk position while keeping your initial objective—profit if the stock stays in a tight range—intact (see figure 3).

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Figure 3: A TALE OF TWO STRANGLES. By pairing a near-the-money short strangle with a further out-of-the-money long strangle—thereby turning it into an iron condor—you can define your risk parameters while keeping your premium-earning strategy intact. For educational purposes only.

Encyclopædia Britannica, Inc.

Refer again to the option chain, and return to our example—selling a 200/210 strangle for $5.25. Your maximum profit is $525, and your breakeven points in the stock are $194.75 and $215.25. Any move in the stock outside those breakeven points would make this a losing trade—theoretically unlimited. And remember: for that reason, your broker might not even allow you to place this trade unless you have lots of capital in a margin account.

By buying a further out-of-the-money strangle, such as the 190/220 strangle for ($1.35 for the 190 put + $1.20 for the 220 call) = $2.55, you would lower your maximum profit from $525 to ($5.25 – $2.55) x 100 = $270, but you would change your worst-case scenario loss. Instead of unlimited risk, your maximum loss would be the difference between the strikes in your iron condor minus the premium you collected.

In this case, the difference between each of your long and short strikes is $10, and the net premium you collected for the iron condor is $2.70. So in a worst-case scenario—a blowout move up or down in the stock below $190 or above $220—the most you would lose is ($10 – $2.70) x 100 = $730.

For each option expiration date, you can typically choose from dozens of strike prices. Before placing an iron condor (or any option trade, for that matter), look at the premiums of different strike prices—and expiration dates—and select a combination of strikes that fits in with your expectations and overall risk tolerance. For example, instead of selling the 200/210 strangle, you could instead sell the 202.5/207.5 strangle and buy the 190/220 strangle. The iron condor would come with a couple bucks more in net premium up front, but your maximum loss would extend by $2.50.

Is that a better risk/reward profile? It could be. Strike selection is, to many traders, a blend of art and science.

Interested in playing an earnings report or news event by using strangles? Just remember that a small loss can quickly turn into a big one. Suppose you’re long a strangle going into an earnings report. Once the news is out, an option might lose more than half of its extrinsic value between the announcement and when the options market opens the next day. It’s called a post-earnings volatility crush.

And if you’re short a strangle, a big move can put a massive dent in your trading account. Although an iron condor will put a stop-the-bleeding floor on any losses, the cost (depending on which strikes you select) will lower your maximum profit on the trade. Plus, every option trade has transaction costs—even in the days of commission-free trading. Multi-leg spreads typically mean higher transaction costs.

And one final reminder: you don’t need to wait until expiration to close out an option trade. Once your objectives have been met—an earnings report, a short position that has captured the majority of the time decay, or a trade that hasn’t gone your way and you’ve hit your pain point—shut it down and move on to the next trade.