Option Trading Strategies - Straddles And Strangles

Straddle:  An option spread that combines an at the money call and put.

A long straddle is the buying of an at the money call and at the money put with the same expiration.  This option position has limited risk and unlimited profit potential.

A short straddle is the selling of an at the money call and at the money put with the same expiration.  This option position has unlimited risk and limited profit potential.

Strangle:  An option spread that combines an out of the money call and put.

A long strangle is the buying of an out of the money call and an out of the money put with the same strike and same expiration.  This option position has limited risk and unlimited profit potential.

A short strangle is the selling of an out of the money call and an out of the money put with the same strike and same expiration.  This option position has unlimited risk and limited profit potential.

As an option trading strategy, long straddles and strangles are done as volatility trades, where you have low historical volatility and are looking for this to expand.  You really don’t care which direction the underlying goes, just that there is a big move coinciding with an increase in volatility. 

In comparison, short straddles and strangles would be done when you have high historical volatility and are looking for the to go back down.  You really don’t care which direction the underlying goes, just that there is a small move coinciding with a decrease in volatility. 

You can see the impact of volatility from the option pricing model.  You buy a long 25 straddle when volatility is 35%, possibly during a market slowdown that has seen volatility go down in general. And then a few days later there is an important economic release that causes a 2% move in the market and an even bigger move in your stock.

Look at the model for thv, which is theoretical value, and you can see that this is 2.55 for the straddle when volatility is 35%.  When it goes up to 42% from the news, the thv of the underlying would go up to 2.91 from the increase in the volatility alone.  This is an increase of 14.1% from volatility only, which would be even higher when the change in the underlying was factored.

Here is the profit graph for a long straddle, buying a 25 call for $2.00 and a 25 put for $2.00, or a position cost of $4.00.  You can see that your risk is limited to the cost of the spread, which occurs at the strike price.  Your gain is unlimited in both directions, and is equal to the strike minus the cost for a downside move or the strike plus the cost on an upside move.  After that point the gain is 1:1 with the underlying.

Here is the profit graph for a short straddle, selling a 25 call for $2.00 and a 25 put for $2.00, or a position credit of $4.00.  You can see that your risk is unlimited in both directions, which occurs at the strike minus the credit to the downside or the strike plus the credit to the upside.  After that point the loss is 1:1 with the underlying.  Your gain is limited to what you sold the straddle for, with the maximum gain occurring at the strike price, and decreasing in both directions to your break even at 29.00 or 21.00 = strike price plus or minus the straddle credit.

ere is the profit graph for a long strangle, buying a 20 call for $1.00 and a 30 put for $1.00, or a position cost of $2.00. You can see that your risk is limited to the cost of the spread, which occurs between the put strike minus the cost of the spread and the call strike plus the cost of the spread. Your gain is unlimited in both directions, and is equal to the put strike minus the cost for a downside move or the call strike plus the cost on an upside move. After that point the gain is 1:1 with the underlying.

Long strangles are done to reduce the cost of a straddle, and/or an anticipation of an outlier move in the underlying, like from an earnings report, or a pending fda announcement for a drug stock.

Here is the profit graph for a short strangle, selling a 20 call for $1.00 and a 30 put for $1.00, or a position credit of $2.00. You can see that your gain is limited to what you sold the spread for, which occurs between the put and call strikes, with your break even at the put strike minus the credit or the call strike plus the credit. Your risk is unlimited in both directions below or above your break even points, and is then 1:1 with the underlying.

Short strangles are done to reduce the risk of a short straddle, and/or after an outlier move in the underlying and a large expansion in volatility, looking for a reversion back to mean volatility and with that a decrease in the amount of the strangle.

Additionally, someone may use this as an income strategy by selling these strangles outside of a stock’s recent range, anticipating that the stock will remain in the range and be able to profit from the credit.