A straddle is the simultaneous purchase or sale of an equivalent number of calls and puts on the same underling stock with the same strike and same expiration. The straddle buyer is looking for a large move by the underlying shares before the options expire, but is unsure of the eventual direction of the move. If the underlying stock's subsequent move results in 1 of the options having a premium more than the amount of the combined premium paid for the 2 options, the straddle buyer will begin realizing a profit.
A strangle is the simultaneous purchase or sale of an equal number of puts and calls on a given underlying stock with the same expiration date but different strike prices. Typically, the call will have a strike above the current stock price, while the put's strike will be below the stock price. As with a straddle, the strangle purchaser is looking for a large move by the stock that exceeds either strike level by more than the amount of the premium paid for both options.
Sellers of straddles and strangles are looking for little to no movement from the underlying stock. These sellers will generally look for options with higher implied volatilities that provide more premium. These positions will be profitable if the stock price stays within the range bounded by the strike prices of the sold options plus the premium collected. Sellers will also benefit if the options' implied volatilities decrease, which would make the options cheaper to buy back if the seller wished to close his position.
Table 1 summarizes the characteristics of these 4 strategies. Note that an important distinction between straddles and strangles is that the strangle buyer is willing to give up profits the straddle buyer would achieve on modest moves for a bigger profit on very large moves. The strangle seller is willing to forego bigger gains on smaller moves in exchange for having more "wiggle room" that will keep the sold options out of the money.
To illustrate, we turn to the hypothetical index XYZ (XYZ). Let's say that it is March and that you don't expect XYZ to experience any major moves prior to April options expiration. With XYZ trading right around $48, you could initiate a short straddle position by writing (selling) both the XYZ April 48 call and the April 48 put. For the sake of this example, let's say that you sell the 48-strike calls for $4.20 per option, or $420 per contract, and sell the 48-strike puts for $3.40 per option, or $340 per contract. The chart below illustrates the possible outcomes of this short straddle position at expiration.
Note in the above chart that the maximum profit (1) is the combined premium received, or $7.60 per pair of options sold ($4.20 + $3.40), while the break-even points (2 and 3) are $55.60 ($48 + $7.60) and $40.40 ($48 - $7.60). Thus, this sold position will be profitable if XYZ stays within a range bounded by $40.40 and $55.60, which is equivalent to a move of plus or minus 15.8% from the initial XYZ price of $48.
However, let's say you wanted a bit more "wiggle room" to accommodate your own risk tolerance levels. As such, you might look to a short strangle position. Using XYZ again, you could simultaneously sell the XYZ April 43 put and 53 call. Let's continue to assume that the index is trading around $48 per share. For the sake of this example, let's say that you sell the 43-strike puts for $1.50 per option, or $150 per contract, and sell the 53-strike calls for $2.10 per option, or $210 per contract. The chart below illustrates the possible outcomes of this short strangle position at expiration.
As shown above, the maximum profit at expiration for this written position occurs between XYZ prices of 43 (1) and 53 (2), as both the put and call are worthless within this range. Above 53, the call will be in the money, thus lowering the profit for the writer. Below 43, the put will become in the money. The two break-even points are calculated by subtracting and adding the premium received ($1.50 + $2.10 = $3.60) to the strike prices of the put and call, respectively. In other words, this position will break even if the put or call is in the money by an amount equal to the premium received for both options. In this case, the lower break-even point (3) is $39.40 ($43 minus $3.60) and the upper break-even point (4) is $56.60 ($53 plus $3.60). Thus, XYZ would have to move plus or minus 17.9% for this position to be unprofitable to the seller at expiration.
Table 2 (seen below) illustrates the profit of each strategy over a range of XYZ prices at expiration. This comparison shows that one strategy is not necessarily "better" than the other - there are tradeoffs that must be considered. Note how the maximum dollar profit of the straddle ($7.60) is greater than that of the strangle. (The margin required for a straddle sale will also likely higher, so the return on margin will not necessarily be greater for straddles).
The strangle, however, will enjoy a maximum profit over a 10-point range, while the straddle achieves peak profitability at the 48 strike only. Also note how the strangle is profitable over a wider range and how its losses will always be one point less than the straddle's. As with all option plays, it's your expectation for how far and how fast the underlying stock or index will move that should determine the type of strategy to use.
Buying or selling straddles and strangles isn't for everyone. It requires strict attention to the price and volatility of the underlying stock, and to the implied volatilities of the options. Commissions are also a consideration, since 2 options are involved. Selling these positions is suited for the more experienced trader, due to the unlimited risk that comes with the potential to profit if the underlying closes within a certain range. Plus, we would not advise selling straddles or strangles in a highly volatile market environment. The advantage of these strategies is that you don't need to call the direction of the underlying; you just need to be confident about how large (or small) and how quickly (or slowly) it will move.
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