What is an Inverted Strangle?
An inverted strangle can be described as very similar to a regular strangle, but instead of the call option being of a higher strike price than the put option, it is the other way around.
However, this explanation of an inverted strangle only makes sense if you understand what a regular strangle is. So, before we analyze what an inverted strangle is, let's first cover the basics of a regular strangle.
What is a Strangle?
A strangle involves buying both a call and a put option of the same asset. The key to a strangle is that the put and the call options have different strike prices but the same expiration date.
A strangle is a neutral strategy, so there is a very high probability to make money. Some would say as high as 70% if the trade is executed correctly.
Usually, a trader would buy an out-the-money (OTM) call and put option. With a short strangle, a trader would short both an out-the-money call option and an out-the money put option. In a regular strangle, regardless of whether it is being bought or shorted, the call option's strike price will always be higher than the put option.
How to enter an Inverted Strangle?
The first thing to do when attempting an inverted strangle is to identify a stock that could work. In the case of an inverted strangle the put option would have a higher strike price than the call option. In order to better understand it, let's look at an example.
Let's say that Intel (INTC) provides optimal conditions for an inverted strangle and is trading at approximately $50 per share.
The put option has a strike price of $50, for a cost of $700 ($7 per share), while the call option has a strike price of $45 for a total of $100 ($1 per share). It is important to make sure that both have the same expiration date.
Here we see that the put option has a higher strike price than the call option and could be seen as in-the-money ITM. For it to be a successful inverted strangle at least one of the options must be ITM, so this is important to note.
You will collect profit as long as you have enough premium, and should be able to calculate profit and loss in an excel spreadsheet.
In this case it would be better to short both the call and the put option, providing a maximum profit would be approximately $600. Similarly, maximum loss would be $600.
Advantages of an Inverted Strangle
Due to the fact that an inverted strangle guarantees profit over a certain range, minimizing risk overall, this is a relatively good risk management strategy in comparison to simply buying or selling a single call or put option in which money will either be made or lost depending on if the value of the option is above or below a single number.
Likewise, in all other options trading strategies, there is also a maximum loss, so it is easy to know what is at risk, as opposed to shorting a stock in which the potential loss is theoretically infinite.
As long as the expiration date for the options are far enough away, a trader also has the luxury of being able to wait the market out. Time is one of the most useful things to a trader, and because there is a maximum loss, they would be able to wait as long as they are prepared to accept that loss.
Disadvantage of an Inverted Strangle
Like with all risk management strategies, the more risk is managed, the more profit is restricted. As well as a maximum loss, there is also a maximum profit that can be made on the trade.
Likewise, many people find it difficult, if not impossible to calculate fees and commissions, and in the case of traders using smaller amounts of capital, the maximum profit might not be enough to break even when the fees and commissions are taken into account.
Inverted strangles are also extremely complex. They can be difficult to enter, or traders might find themselves in the situation by pure chance as they manage their regular strangles through market volatility.
Many trading platforms do not recommend trading the inverted strategy at all, and because of that there are very few examples that can be studied in order to perfect the technique, meaning that traders who are considering it would have to do their own backtesting in order to make sure that they understand how to use the strategy before they get started.The inverted strangle is also not suitable for all kinds of traders. Because of the use of options, it is more suitable for traders who are prepared to hold a position for several months at a time. The more money a trader is able to put into it, the more likely they would be to make up for commissions and fees as well. This means that the average day trader, or swing trader would not be able to experiment with it at all.
Should You Use the Inverted Strangle?
Considering all the factors that we have discussed above, the issues with the complexity of the inverted strangle, as well as the fact that there is so little information out there to study about it, it may be better to avoid the inverted strangle wherever possible.
This does not mean that you should exit the trade immediately if you find yourself in an inverted strangle after managing a regular strangle, but it is advised that you do not enter one on purpose.
Instead, it may be better to wait for the market volatility to calm down in order to minimize risk, especially if you are a slightly less experienced trader. The key to successful trading is risk management, so always make sure that you understand everything about every trade that you enter into, and that you never trade more than you are willing to lose at any given moment.
You might be also interested in What is a Poor Man’s Covered Put? and Poor Man’s Covered Call.