Derivatives - Straddles and Strangles

Traders who strongly believe the price of an underlying asset will change significantly in the near future but are unsure about the direction of the move can trade combinations of options that differ only in the exercise price. A common combination is straddles and strangles. These are option trading strategies that combine both puts and calls to create positions that do not depend on the direction of the market movement for their profitability. Long straddles and strangles make money if the stock price moves up or down significantly.

A long straddle is long one call and long one put at the same strike price and expiration and on the same stock. A long strangle is long one call at a higher strike and long one put at a lower strike in the same expiration and on the same stock. Such a position makes money if the stock price moves up or down well past the strike prices of the strangle. There are higher costs and risk involved with these strategies, as we discuss below.

Straddle
An options strategy where the investor holds a position in both a call and put with the same strike price and expiration date, but with different exercise prices. This strategy is illustrated in the following diagram.
 

Straddles are a good strategy to pursue if an investor believes that a stock's price will move significantly, but is unsure as to which direction. The stock price must move significantly if the investor is to make a profit. As shown in the diagram above, should only a small movement in price occur in either direction, the investor will experience a loss. As a result, a straddle is extremely risky to perform. Additionally, on stocks that expected to jump, the market tends to price options at a higher premium, which ultimately reduces the expected payoff should the stock move significantly.

Strangle
An options strategy where the investor holds a position in both a call and put with different strike prices but with the same maturity and underlying asset. This option strategy is profitable only if there are large movements in the price of the underlying asset.

This is a good strategy if you think there will be a large price movement in the near future but are unsure of the direction of that movement.

The strategy involves buying an out-of-the-money call and an out-of-the-money put option. A strangle is generally less expensive than a straddle as the contracts are purchased out of the money.

For example, imagine a stock currently trading at $50 a share. To employ the strangle option strategy a trader enters into two option positions, one call and one put. Suppose the call is for $55 and costs $300 ($3 per option x 100 shares) and the put is for $45 and costs $285 ($2.85 per option x 100 shares). If the price of the stock stays between $45 and $55 over the life of the option, the loss to the trader will be $585 (total cost of the two option contracts). The trader will make money if the price of the stock starts to move outside of the range. Suppose that the price of the stock ends up at $35. The call option will expire worthless and the loss will be $300 to the trader. The put option, however, has gained considerable value - it is worth $715 ($1,000 less the initial option value of $285). Therefore, the trader's total gain is $415.

Option Prices and the Time to Expiration
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