2 Top Volatility Strategies for Options Traders

Plus, why both strategies need to be executed in different scenarios

Assistant Editor
Feb 18, 2021 at 11:01 AM
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    With all the recent market volatility, new and experienced traders alike are looking for the perfect strategy to get ahead in the game. We think a return to the basics could help everyone looking to gain a little more knowledge when it comes to options trading. This week, we'll dive into the difference between the straddle and the strangle, and hopefully open some eyes to the benefits of both plays.  

    The Straddle Method

    First up is the straddle. The straddle is a two-legged options trading strategy that's designed to capitalize on high volatility. To construct a straddle, the trader buys to open a call and a put on the same stock, with the same strike price and expiration date. Essentially, the speculator has initiated simultaneous bullish and bearish trades, allowing the straddle to return a profit no matter which direction the underlying stock moves.

    So, why isn't it a good idea to play a straddle on every stock, every time, just to guarantee a winning trade? Because two options are purchased instead of one, the breakeven point on a straddle is significantly higher (or lower, on the put side) than with a single-option strategy. As a result, the equity needs to make a major directional move to offset the higher cost of entry -- a modest uptick or pullback isn't going to cut it.

    Plus, if the stock moves sideways through expiration, the straddle buyer may incur a nearly 100% loss on both options, whereas a straightforward call or put buyer would be out the cost of only one option. While they're not ideal for every trading scenario, straddles can be a very profitable strategy when the underlying stock is expected to experience a significant rise in volatility during the time frame of the trade.

    The Strangle Method

    Next, the strangle is a very close cousin to the straddle, as it consists of simultaneous bullish and bearish trades on the same underlying stock. The idea is to profit from a big directional move, regardless of whether the stock rallies or plummets. As with a straddle, the strangle trader buys to open a call and a put on the same stock, with both options sharing the same expiration date.

    However, unlike a straddle, the strangle involves a call and a put at two different strike prices. Most frequently, both strikes will be out of the money, surrounding the current stock price. By implementing this bullish volatility play with out-of-the-money options, the strangle trader can frequently obtain a lower cost of entry than the straddle player. On the other hand, this also means the strangle trader needs a relatively bigger move out of the underlying stock just to reach breakeven.

    Due to these features, the strangle is best-suited only to those situations where the underlying stock seems likely to make a major directional move. Otherwise, the trader risks taking a 100% loss on both of his purchased options.

     

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