The difference between straddles and strangles
Options straddles and options strangles are two advanced options strategies that can be used to capitalize on changes in implied volatility (IV) and stock price volatility. Options straddles and options strangles are both strategies that involve buying both a call option and a put put with the same expiration date and strike price, but with different premiums. The risk with options straddles and options strangles is limited to the premiums initially paid for the two options. If both options expire worthless, the trader keep keeps the premium as a profit.
The difference between an options straddle and an options strangle is time. Both strategies have the same time premium in them, so the profit potential is equal. But an options straddle has more time value and can lose more if there is little movement over the life of the trade. If there is no movement, a trader loses only the cost of buying the options, whereas a trader holding a strangle loses everything except the small amount of time premium paid for the trade.
In this article, we will discuss the difference between options straddles and options strangles while providing examples of the strategies. We will also discuss the strategies' relationships with Implied Volatility.
Options Straddles Versus Options Strangles
Straddles offer limited risk but unlimited profit potential, while strangles have limited profit potential but unlimited risk. This is because the maximum gain or loss is defined at the trade initiation. So, if a trader is looking for ways to make money from volatility, consider these strategies.
Options straddles and options strangles are two-legged strategies involving a limited risk, defined maximum gain or loss, and unlimited profit potential. Strikes for both legs of the trades must be selected carefully so that the maximum profit on the trade exceeds the cost of buying into the position and that the breakeven point is as close as possible to the current market price for the options.
A call straddle is created by buying one call option at a specific strike price and selling another put option at the same strike price with the same expiration. A trader is essentially buying the stock for a known cost and selling it for what it may be worth in the future which is, hopefully, more than what was paid for it with the first option. The call straddle strategy is used when a trader anticipates a significant change in the price of an underlying instrument but is not certain whether that change will be a large price increase or a large price decrease.
The concept behind a strangle is similar, except that a trader would buy one call option with a higher strike price and sell another call option at a lower strike price. A strangle has more significant profit potential than a straddle as well as greater risk because of the spread between strikes. Options strangles are constructed by buying an out-of-the-money call and an out-of-the-money put with the same expiration date but with different strike prices. A long strangle has a negative position delta and is a bearish options strategy, while a short strangle is a bullish options strategy.
Straddles and strangles can be sold on individual stocks or exchange-traded funds (ETFs).
How Options Straddles and Options Strangles May Fit Your Portfolio
Options straddles and options strangles are remarkably similar strategies. Both options strategies involve using a call and a put option on the same underlying security with the same expiration date. Where the strategies differ is in how they are set up. In an options straddle, both options have the same strike price. However, the call has a higher strike price than the put in an options strangle.
Straddles and strangles can be used for three primary reasons:
- To capitalize on anticipated price movement in one direction or another—whether it’s rising or falling;
- To hedge a position (to protect against significant losses); or
- To create an option combination that has low risk, low cost, and limited profit potential—allowing you to profit from volatility expansion in underlying security without having to predict which way prices will move.
Implied Volatility with Options Straddles and Options Strangles
One of the essential tools for a successful options trader is a solid understanding of implied volatility. Implied volatility measures how volatile the underlying security is expected to be and is also a gauge of market sentiment. Implied volatility can be used to create strategies that are both bullish and bearish. The key to any successful straddle or strangle is that its implied volatility must be pretty high because, if it isn’t, the strategy won’t produce profitable results.
If implied volatility is high, the long straddle position will go in-the-money fairly quickly because volatility is high, but the trade can also expire worthless if the implied volatility doesn’t rise or fall significantly enough. On the other hand, the long strangle position will lose money if the implied volatility doesn’t rise or fall significantly enough but can still turn a profit even if it rises or falls dramatically because of the premium is collected when the trade is initiated.
Because a straddle contains more time value, it can still show a profit if there’s minimal movement in either direction. This means that both trades have neutral breakevens as long as the implied volatility remains relatively constant, which means that if implied volatility remains unchanged after one enterd into one of these trades, a trader can keep them open until expiry.
The maximum loss of a long straddle or long strangle is equal to its initial cost, plus commissions. The maximum gain is unlimited at expiration; however, it’s unlikely to happen unless you have a catalyst for your forecasted move in volatility.
Options Straddles Example
The straddle buyer is expecting a significant move in price and volatility. Specifically, the trader expects an effective action either up or down and believes they can capture that move by buying both a call and a put. So, let’s assume that our market participant is expecting a significant move to the upside, with IV rising from 12% to 20%. They would buy an ATM ($50) call option with a strike price of $50.00 and purchase an ATM put option with a strike price of $50.00 for a total cost of both options. If, at expiration, the stock was trading above the $50.00 strike price, then the trader would exercise their call option, which would give them profit with a protected backside risk. If, at expiration, the stock was trading below the $50 strike price, the trader would exercise the put option.
Options Strangles Example
The strangle buyer is also expecting a significant move in price and volatility. Specifically, the trader expects a substantial move to the upside and believes that they can profit off the increase while protecting themselves by buying both a call and a put. They would buy an OTM ($55) put option with a strike price of $50.00 and purchase an OTM call option with a strike price of $55.00 for a total cost of both options. If, at expiration, the stock was trading above the $62.00 strike price, then the trader would exercise their call option, which would give them profit with a protected backside risk. If, at expiration, the stock was trading below the $50 strike price, the trader would exercise the put option.