Straddles and Strangles

A straddle is the simultaneous purchase or sale of an equivalent number of both 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 before the options expire, but is unsure of the eventual direction of the move. If the underlying's subsequent move results in one of the options having a premium more than the amount of the combined premium paid for the two 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 four 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 the big profit on the 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 an example from March 8 using the Nasdaq 100 Trust (QQQ). For the QQQ, we noted a number of large block trades on both the April 48 call and April 48 put (a straddle) that occurred late in the trading session. With QQQ trading right around 48, this appeared to be an at-the-money straddle. The calls went off at 4.20 and the puts at 3.40, and both were generally at or below the bid price. What's more, the volume of these trades dwarfed the amount of previous open interest (as it turned out, 50,000 positions were added to each option's open interest that day). From this, we surmised that this was the opening of a straddle sell, the intent of the seller being that QQQ would not experience any major moves prior to option expiration on April 20. Chart 1 illustrates the possible outcomes of this short position at expiration.

Note in Chart 1 that the maximum profit (1) is the combined premium received, or 7.60 per pair of contracts sold (4.20 + 3.40), while the breakeven points (2 and 3) are 55.60 (48 + 7.60) and 40.40 (48 - 7.60). Thus, this sold position will be profitable if QQQ stays within a range bounded by 40.40 and 55.60, which is equivalent to a move of plus or minus 15.8 percent from the initial QQQ price of 48.

The other trade that caught our eye on March 8 was an apparent strangle position involving the QQQ April 43 put and 53 call. From the following day's open interest figures, it was obvious that these were new positions, as open interest on both options soared by 100,000 contracts. The options also transacted at or below the bid at 1.50 and 2.10, respectively, suggesting another written position (short strangle). With QQQ at 48, each of these options was out of the money by five points at the time of the trade. Thus, the maximum profit to the seller (3.60 per contract pair) is achievable as long as these options remain out of the money, i.e., QQQ trades between 43 and 53 until expiration. Chart 2 shows the profit and loss possibilities of this short position.

As shown above, the maximum profit at expiration for this written position occurs between QQQ 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 breakeven points are calculated by subtracting and adding the premium received (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 breakeven point (3) is 39.40 (43 minus 3.60) and the upper breakeven point (4) is 56.60 (52 plus 3.60). Thus, QQQ would have to move plus or minus 17.9 percent for this position to be unprofitable to the seller at expiration.

Table 2 illustrates the profit of each strategy over a range of QQQ 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 two 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 (witness the tenuous position of the short positions outlined here). 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.