Option Strategies – The Straddle and Strangle
One of the most intriguing things about options trading is the variety of choices available to the educated trader. With dozens of option strategies available, competent traders can analyze the market conditions, their personal risk tolerance, and their financial objectives, and then choose the option strategy that best fits all criteria. Some traders find one or two option strategies that work best for them, while others utilize numerous strategies depending on the market situation they encounter.
The key for any option strategy is to know the market conditions that need to be present to use the strategy, to know how to execute the strategy, and to know whether the strategy fits within their risk parameters. When a trader anticipates a move to the upside, there are several strategies that the trader can utilize. For example, a trader may buy the stock, purchase a call, or use a bull-call spread. Correspondingly, when a trader anticipates a move to the downside, they may short the stock, purchase a put, or use a bear-call spread. The choice in strategy often depends on the trader’s personal trading rules, based on their risk tolerance and financial objectives.
There are also market conditions that many traders encounter when they anticipate a large movement in the price of a stock but are unsure of what direction the price will go. For example, the earnings report of a stock may be coming up, and a trader’s analysis indicates that a potential large movement may occur based on what the earnings report shows. A trader may also encounter a very volatile market and want to use option strategies that will allow them to profit from a rise in volatility. In these situations, some of the most widely used option strategies are the straddle and strangle.
Straddle Overview
Straddles are very straightforward and simple in their execution. A straddle is executed when:
An equal number of calls and puts are purchased at the same strike price (ideally, at the money) with the same expiration date.
Straddle Trade Evaluation:
Cost: Price of call option + Price of put option + Commissions
Maximum Reward: Unlimited
Maximum Risk: Price of call option + Price of put option + Commissions
Upper Breakeven: Call strike + cost
Lower Breakeven: Put strike - cost
As all traders know, there are only three directions a stock can move: up, down, or sideways. The straddle is a bi-directional strategy designed to capture profitsno matter what direction the stock goes.
When Are Straddles Used?
Traders typically utilize straddles before expected important news events, such as earnings reports or major economic announcements that might greatly affect the overall market or the underlying stock. Because straddles involve the purchase of at-the-money calls and puts, the trade has potential to make money regardless of how the market reacts to the news.
Because at-the-money options are used in the trade, traders ideally want to enter straddles when implied volatility is relatively low, or if you are expecting a rise in volatility. At-the-money options are sensitive to changes in implied volatility and if you experience a drop in volatility, your options will likely decrease in value. Conversely, increases in volatility will likely cause your options to increase in their immediate value as option premiums become more expensive.
An important note: Because of time decay, many traders develop rules that close out straddle trades at least one month before expiration.
Risk Analysis
While straddles can capture profits in both bullish and bearish moves, one of the main drawbacks to straddles is the inherent cost to purchase both a call and put option. Because the straddle utilizes at-the-money strike prices, there will be little to no intrinsic value with the options you purchase.
A risk to reward ratio must be conducted in accordance with your own personal trading rules. If implied volatility is high at the time you enter the trade, then the cost of the options premium likely will cause the risk associated with the trade to be out of balance with the potential rewards in a movement of the underlying stock price.
Managing the Trade
When the news breaks, one side of your trade may quickly increase in value, but that will also mean that the other side of your trade will be decreasing in value. Your exit strategies and how you manage your trade will likely impact the profitability of your straddle trade. There are several techniques you can use as your exit strategy:
1) If you entered a straddle trade based on a news event (i.e., earnings) and the news creates a large movement in price based on the news event, you can exit both sides of the trade and take your profits. If you stay in your trade, then you risk having the stock revert to previous trading ranges.
2) One thing that you should always be aware of with a straddle is the inherent drawback that many options have - time value. If the expected move does not occur, then both the put and the call option will lose value every day. At this point, you can choose to do one of two things:
a. Close out both sides of the trade. Both the put and call option will likely have lost some value at this point. However, if your initial reason for the trade is no longer present, then you will need to evaluate your reasons to stay in the trade.
b. Close one side of the trade. Your technical analysis may indicate that there is reason to stay in one side of the trade and not the other. You should have a valid reason for doing this based independently on the technical data available to you.
3) If you experience a rise in implied volatility before the news event that makes your trade profitable before the news event, then you can exit the trade with a profit. If you believe that implied volatility may be peaking, it might be wise to take your profits and move onto another trade.
The most important thing to remember in any trade is to have your trading rules established in advanced so you are not winging it. The best traders are calculated, and know how they will react in the various market conditions they encounter.
Straddle Example
Company XYZ is announcing earnings in seven weeks. Your analysis of the company’s history indicates that there have been large moves around the last couple earnings, and that the stock is prone to large movements. Implied volatility has been relatively low, and you believe a straddle trade might also benefit from spikes in volatility in the coming weeks.
XYZ is currently trading at $25.00, and you explore strike prices two months out. The 25 call options are selling at $2.50, and the $25 puts are $2.00. If you bought one contract of each, your trade would have:
Net Debit = $450
Max Risk = $450
Max Reward = Unlimited
Upper Breakeven = $29.50
Lower Breakeven = $20.50
Your worst scenario would be if the stock stayed at $25.00 after the earnings announcement, as that would be your maximum loss. Both the call and the put are likely to retain some time value as long as you are not close to expiration. Your actual breakeven points will be much closer to the current price, as long as there is not a drop in volatility or you hold the trade within several weeks of expiration.
Strangles
Strangles employ the same basic strategy that is used involving straddles. The main difference is the structure of the trade. Where the same strike price is used for straddles, different strike prices are utilized for strangles. For example, with a straddle, you might:
• Buy an at-the-money call
• Buy an at-the-money put
With a strangle, you would purchase a call and a put option at different strike prices. For example:
• Buy an out-of-the-money call
• Buy an out-of-the-money put
Because you are utilizing different strike prices, at least one of the strike prices will be out of the money. At times, both of the strike prices will be out of the money. This naturally creates a lower cost basis for the trade, and the trade will carry less risk. It must be noted, however, that while there will be less initial cost, the breakeven points will be farther out as well. The stock will have to have a larger move to produce profits. If you choose to utilize the out-of-the-money strangle strategy instead of a straddle, there must be some reasoning behind the strike prices you purchase (i.e., the stock has demonstrated that it can make that type of move in the timeframe). If you simply buy them because they are cheaper, then you are entering the mindset of the gambler.
Another reason traders sometimes employ the strangle over the straddle is that they believe there is a stronger likelihood the stock will move one direction, but still want to capture the movement in the other direction in case the stock doesn’t behave as anticipated. This type of trade is not for the novice, as correctly guessing the impact news will have on a stock price is extremely difficult.
Strangle Example
Company XYZ is currently trading at $60 a share. Your analysis of the stock’s history indicates dramatic movement historically around earnings. You decide to employ a strangle purchasing the $65 call for $200 and the $55 put for $175. There is also currently relatively low volatility, making option premiums cheaper and giving you the ability to profit from spikes in volatility.
Net Debit = $375
Max Risk = $375
Max Reward = Unlimited
Upper Breakeven = $68.75
Lower Breakeven = $51.25
If the stock does not move about $65 or below $55, then your options will expire worthless, and you would experience maximum loss of $375 per contract. As noted above with the straddle, however, the call and the put are likely to retain some time value as long as you are not close to expiration.
Next month, we will discuss one of the most popular cash flow generating option strategies available, the iron condor.