Straddle vs. a Strangle: An Overview
Straddles and strangles are both options strategies that allow an investor to benefit from significant moves in a stock's price, whether the stock moves up or down. Both strategies consist of buying an equal number of call and put options with the same expiration date. The difference is that the strangle has two different strike prices, while the straddle has a common strike price.
Options are a type of derivative security, meaning the price of the options is intrinsically linked to the price of something else. If you buy an options contract, you have the right, but not the obligation to buy or sell an underlying asset at a set price on or before a specific date. A call option gives an investor the right to buy stock and a put option gives an investor the right to sell stock. The strike price of an option contract is the price at which an underlying stock can be bought or sold. The stock must rise above this price for calls or fall below for puts before a position can be exercised for a profit.
Let's say a company is scheduled to release its latest earnings 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 move sharply higher or lower.
Let's assume the stock is trading at $15 in the month of April. Suppose a $15 call option for June has a price of $2, while the price of the $15 put option for June is $1. A straddle is achieved by buying both the call and the put for a total of $300: ($2 + $1) x 100 shares per option contract = $300. The straddle will increase in value 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.
While a straddle has no directional bias, 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 a company's results will be positive, meaning you require less downside protection. Instead of buying the put option with the strike price of $15 for $1, maybe you look at buying the $12.50 strike that has a price of $0.25. This would cost less than the straddle and also require less of an upward move for you to break even. Using the lower-strike put option in this strangle will still protect you against extreme downside, while also putting you in a better position to gain from a positive announcement.
Understanding what taxes must be paid on options is always complicated, and any investor using these strategies needs to be familiar with the laws for reporting gains and losses.
IRS Pub. 550: Capital Gains & Losses: Straddles provides an overview. In particular, investors will want to look at the guidance regarding "offsetting positions," which the government describes as a "position that substantially reduces any risk of loss you may have from holding another position.”
At one point in time, some options traders would manipulate tax loopholes to delay paying capital gains taxes—a strategy no longer allowed. Previously, traders would enter offsetting positions and close out the losing side by the end of the year to benefit from reporting a tax loss; simultaneously, they would let the winning side of the trade stay open until the following year, therefore delaying paying taxes on any gains.
Current "loss deferral rules" in Pub. 550 say that an individual can deduct a loss on a position only to the extent that the loss is more than any unrecognized gain the person has open on offsetting positions. Any "unused losses are treated as sustained in the next tax year.”
There are more rules pertaining to offsetting positions and they are complex and at times, inconsistently applied. Options traders also need to consider the intricate wash sale loss deferral rules, which would apply to traders that use saddles and strangles as well.
Rules have been set up by the IRS—as outlined in IRS Pub. 550: Capital Gains & Losses: Wash Sales— to discourage investors from trying to take a tax deduction from a security sold in a wash sale. A wash sale occurs when a person sells or trades a security at a loss and then, either 30 days before or after the sale, buys a "substantially identical" stock or security, or buys a contract or option to buy the stock or security. A wash sale also occurs when an individual sells a security and then the spouse or a company run by the individual buys a "substantially identical" stock or security.
Because the rules are complex, any investors dealing in options needs to work with tax professionals who understand the complicated laws in place.
- Straddles and strangles are options strategies investors use to benefit from significant moves in a stock's price, regardless of the direction.
- Straddles are useful when it's unclear what direction the stock price might move in, so that way the investor is protected, regardless of the outcome.
- Strangles are useful when the investor thinks it's likely that the stock will move one way or the other but wants to be protected just in case.
- There are complex tax laws investors need to understand regarding how to account for gains and losses as a result of options trading.