A strangle is a slight modification to the Straddle to make it cheaper to execute. This strategy involves simultaneous buying of two options. One is a slightly out-of-the-money (OTM) put. The second a slightly out-of-the-money (OTM) call. Both are of the same underlying stock/index and expiration date. Here again the investor is direction-ally neutral. However, he is looking for an increased volatility in the stock/index. He also expects the prices to move significantly in either direction. The cost of executing a Strangle is usually cheaper as compared to a Straddle. That is because OTM options are purchased for both Calls and Puts where generally ATM strikes are purchased for a straddle.
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.
For example, suppose the ATM Strike for Nifty is 8200. The trader, using a Long Strangle Strategy, would buy a 8400 Call and a 8400 Put at the same time. The different between this and a Long Straddle Strategy is that with a Strangle, if the the underlying does have volatility, the trader can earn more with the 8400 Strangle versus a 8200 Straddle assuming the volatility is high enough. Therefore, the trader is better on not just volatility, but a high amount of it in order for the strategy to be a success.
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