An option strangle or straddle is an option strategy that option traders can use when they think there is an imminent move in the underlying but the direction is uncertain. With either of these strategies, the trader is betting on both sides of a trade by purchasing a put and a call simultaneously. An option strangle is generally just out-of-the-money (OTM) but with the same expiration. It is usually used when the underlying is between strike prices. An option straddle is when the underlying is trading at or close to a strike price and the same call and put strike are purchased with the same expiration.
By buying a put and a call that are OTM, an option trader pays a lower initial price than with an option straddle where the call and put purchased share the same strike price. However, this comes with a price so to speak. The stock will have to make a much larger move than if the option straddle were implemented because the breakeven points of the trade will be further out due to buying both options OTM. The trader is arguably taking a larger risk (because a bigger move is needed than with an option straddle) but is paying a lower price. Like many trade strategies there are pros and cons to each.
How Straddles and Strangles Work
To profit from an option straddle or strangle, a big move higher or lower is desired from the underlying. Generally, the position starts out with a neutral or close to neutral delta position. If the underlying moves higher, positive delta from the long call position takes over the position and the negative delta from the long put position starts to decrease. The opposite would happen if the underlying moved lower with negative delta leading the charge.
An option strangle has two breakeven points just like the option straddle. To calculate these points simply add the net premium (call premium + put premium) to the strike price of the call (for upside breakeven) and subtract the net premium from the put’s strike (to calculate downside breakeven). If at expiration the stock has advanced or dropped past one of these breakeven points, the profit potential of the strategy is unlimited (for upside moves). The position will take a 100% loss if the stock is trading between the put and call strikes upon expiration for a strangle and right at the strike price for a straddle. Remember that the maximum loss a trader can take on a strangle or straddle is the net premium paid.
Option Theta Is the Enemy
If you have ever bought an option and the underlying did not move, you have seen negative theta in action. For a straddle or strangle, an option trader has two negative theta positions because of the long call and put. Time is of the essence on a straddle or strangle because the call and put premium is constantly eroding due to the passing of time. It goes without saying that an option trader prefers the underlying to move sooner than later for a straddle or strangle. To decrease negative theta, a farther expiration can be bought but that increases the overall risk and the breakeven points.
Implied Volatility Can Be a Factor
The implied volatility (IV) of the options plays a key role in a straddle or strangle as well. With no short options in this spread, the IV exposure is concentrated with a positive vega position from the long call and put. Option premiums increase when IV rises. When IV is considered low compared with historical volatility (HV), it is a relatively “cheap” time to buy options. Since the option strangle involves buying a call and put, buying “cheaper” options is critical. If the IV is expected to increase after the option strangle is initiated, this could increase the option premiums with all other factors held constant, which is certainly a bonus for long option strangle holders. Of course, if IV decreases after the position is initiated, option premium will decrease similar to theta.
Straddles or Strangles in Front of Earnings
The general idea of a pre-earnings straddle or strangle is to profit from either positive or negative delta, an increase in IV or both. Although past performance is not indicative of future behavior, you would like to find a stock that has a history of price volatility ahead of the announcement. Generally looking at the previous four earnings should give you an indication. As the earnings date approaches, the IV of the options should increase along with the premium from that rise. This is what you plan on capturing in regard to profit, the stock moving a decent amount in one direction and at the same time the option premium increasing due to the rise in implied volatility. Putting on this position should be considered anywhere from about one to four weeks before the expected earnings announcement. Negative theta will still be decreasing premium, but if IV increases it can offset the time decay to a certain degree.
Straddle Example
An option trader notices the chart below with the underlying trading around $114. The stock has potential support down to about $108 and potential resistance around the $125 level.
With just under three weeks to go until expiration, he can purchase a November 114 straddle for a cost of 4.00 (Nov 114 call and Nov 114 put at 2.00 each). This is the maximum risk of the position and that would be realized if the stock closed exactly at $114 at expiration. That makes the breakeven point to the downside $110 (114 – 4 (cost)), which is above the support level. If the stock trades down to support, the straddle will be profitable because the long put will have intrinsic value of 6.00 (114 – 108 (support)), which is greater than the cost of the position.
The breakeven to the upside is at $118 (114 + 4 (cost)). If the stock moves above the breakeven point of $118, the call option will have intrinsic value more than the cost of the straddle. In fact, if the stock reaches the resistance level of $125, the straddle will at least be worth 11.00 (125 – 114), which would mean a profit of 7.00 (11 – 4 (cost)) or $700 in real terms.
Final Words
Unlike with a stock position, a trader cannot make money no matter if the stock goes higher or lower. He needs to be either long and have the stock rise or short and have the stock move lower. An option straddle or strangle allows an option trader to not have a bias and still potentially make money as long as the stock moves a significant amount higher or lower in a certain amount of time.
John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.
