Dawn Pennington

Put a 'Choke' Hold on Profits

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A long strangle is a unique options spread strategy, as spreads are typically designed to cap both your downside and your upside potential. But the long strangle -- in which you purchase a call and a put -- can yield unlimited profit if there are large movements in the price of the underlying asset in the near term, regardless of the direction the stock is trading in.

Think of it this way: When you are putting on a strangle, you are betting on the stock making a big move, but you don't really have to be concerned with which direction because the long call would profit from an upward move and the long put would profit from a downward one.

(There is also a short strangle strategy, in which you short both a call and a put at a given strike price, but this one exposes you to a great deal more risk, which may include taking you out of your long stock position. For this discussion, we'll focus on the long strategy.)

With the long strangle, an investor will incur loss at during options expiration if the underlying stock price is trading between the strike prices of the options that are held long. At this price, both options expire worthless and the options trader loses the entire initial debit taken to enter the trade.

For illustrative purposes only, let's look at how a long strangle might benefit long investors who decide to hang on to stocks that have dropped. Perhaps you hold shares of XYZ Corp., which is currently trading at $23, a few points lower than where it was when you bought it.

Suppose you like XYZ as a long-term investment. But in the short term, you're not sure whether XYZ will recover swiftly or dip sharply before climbing back up.