A:

Straddles and strangles are both options strategies that allow the investor to gain on significant moves either up or down in a stock's price. Both strategies consist of buying an equal number of call and put options with the same expiration date; the only difference is that the strangle has two different strike prices, while the straddle has one common strike price.

For example, let's say you believe your favorite diamond mining company is going to release its latest results in three weeks time, but you have no idea whether the news will be good or bad. This would be a good time to enter into a straddle, because when the results are released the stock is likely to be more sharply higher or lower.

Let's assume the price is currently at $15 and we are currently in April 05. Suppose the price of the $15 call option for June 05 has a price of $2. The price of the $15 put option for June 05 has a price of $1. A straddle is achieved by buying both the call and the put for a total of $300: ($2 + $1) x 100 = 300. The investor in this situation will gain if the stock moves higher (because of the long call option) or if the stock goes lower (because of the long put option). Profits will be realized as long as the price of the stock moves by more than $3 per share in either direction. A strangle is used when the investor believes the stock has a better chance of moving in a certain direction, but would still like to be protected in the case of a negative move.

For example, let's say you believe the mining results will be positive, meaning you require less downside protection. Instead of buying the put option with the strike price of $15, maybe you should look at buying the $12.50 strike that has a price of $0.25. In this case, buying this put option will lower the cost of the strategy and will also require less of an upward move for you to break even. Using the put option in this strangle will still protect the extreme downside, while putting you, the investor, in a better position to gain from a positive announcement.

(For further reading, see Risk Graphs: Visualizing Your Profit Potential.)

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