Trading Option Straddles and Strangles: Part 1
One of the most powerful aspects of trading with options is that there’s an option strategy for almost any situation. Today we’re going to introduce two of those strategies: straddles and strangles. Both straddles and strangles are non-directional strategies, meaning that they have the ability to profit whether the price of the underlying security moves up or down.
A long straddle involves buying a call and a put on the same underlying security. Both options have the same expiration date and the same strike price. The risk profile for a long straddle is shown in the box to the left.
A risk profile, sometimes called a profit diagram, shows how much the option strategy will gain or lose based on the stock price at expiration. All long straddles have a risk profile shaped like a V, with the base of the V falling $C below the horizontal breakeven line, where $C is the total cost of entering the straddle. In terms of the stock price, the base of the V coincides with the strike used for the call and put. In other words, if buying a 125 strike straddle costs $7/share ($700/contract), then the maximum loss will occur if the stock expires at a price of exactly $125, making both options worthless at expiration.
The breakeven points for a long straddle fall $C above and below the strike price. Continuing the example from above, the stock price needs to be below $118 or above $132 at expiration for the straddle to be profitable. The further below $118 or above $132 the stock price is, the more profitable the straddle will be. Therefore, we can see that buying a long straddle is a bet that the stock price will move significantly by expiration.
Not surprisingly, a short straddle is a bet that the stock price will not move significantly before expiration. A short straddle is created by selling (shorting) a call and a put with the same expiration date and the same strike price. The short straddle risk profile is shown in the box to the left. As with all short option strategies, the profit is capped at the amount of premium collected ($P) when the position was entered. With a short straddle, that occurs when the stock price is exactly at the strike price at expiration. If the stock moves more than $P above or below the strike, the position will incur losses, and those potential losses are theoretically unlimited.
Strangles are close cousins of straddles. The difference is that strangles are created by buying (long strangle) or selling (short strangle) a call and a put with the same expiration date and different strike prices. The risk profiles are shown below.
A long strangle is less expensive to establish than a long straddle, because it uses an out of the money (OTM) call and put, rather than the pricier at the money (ATM) options used by the strangle. The disadvantage of the strangle is that the stock price has to move further before the position becomes profitable. For a long straddle with a cost of $C, the lower breakeven point occurs when the stock price expires $C below the put strike, and the upper breakeven point is $C above the call strike. Once the stock price moves outside this range, there is unlimited profit potential.
Similarly, the short strangle garners a smaller premium (max profit) than the short straddle. However, you get to keep the entire premium ($P) as long as the stock price stays between the call and put strikes, so there’s a larger margin of error with short strangles as compared to short straddles. As with the long strangle, breakeven occurs $P below the put strike and $P above the call strike.
In Part 2, we’ll discuss ways to evaluate straddles and strangles.
Click here to read Trading Option Straddles and Strangles: Part 2