When taking on options trading, new commoners usually begin with basic strategies for calls and puts including purchasing puts to provide temporary downside protection and selling covered calls to generate potential income. Although it is not compulsory that you have to move on to using more complex ones like straddle and strangle option strategy, having the overall understanding as well as knowing the differences between straddles and strangles will surely help investors make better decisions in their trading plans.
These two strategies are designed to profit in similar scenarios, whether the stock prices move up or down. It’s either trying to survive and make profits during the market volatility or just holding to your underlying assets and playing it safe for consistent flows of income. Let’s dive deeper into what straddle and strangle are all about in options and their use cases below.
Straddles and Strangles Explained
Unlike other strategies, straddles and strangles are magnitude-driven instead of being based on the direction of the price movement. These two strategies share the process of buying an equal number of calls and puts with the same expiration date. Here’s the end of their similarities. While a straddle options strategy has a common strike price, a strangle includes out-of-the-money calls and puts and has two different strike prices.
Furthermore, the striking distinction between straddles and strangles lies in the cost of implementing and the movement of the stock price before you start to earn your returns, especially strangles, when they may need a bit more extreme fluctuation from the market price.
Common Straddle and Strangle Option Strategy
When you are expecting a change in the stock price but just have no clue of the direction it will head, you can implement the long straddle. The strategy involves buying both a call and a put at the same strike price A and expiration date.
Considered the best of both worlds since the two contracts give the buyer the right to buy as well as to sell the stock at strike price A, with a considerable cost of course. Most of the time, a straddle is set up with the call and the puts are at-the-money or near the strike price as possible.
When running this strategy, you want the high volatility to strike the market and the stock price to go in the most extreme way it can. With the market price rising, the potential returns are theoretically unlimited. If it somehow takes a downtrend, profits will still be substantial and partially limited to the strike price minus the net debit paid according to the contracts.
The short straddle shares a mutual aspect with the long straddle as they only need one strike price. The strategy is often implemented if you are expecting minimal movement in the stock price. When you set up the strategy, sell both a call and a put at the same strike price A and expiration date.
By selling both options, your possible profits will increase more than those you would otherwise achieve from selling a single contract. As the strategy comes to action, you will want the volatility to decrease and the market price to make no sudden changes. If the stock price soars, your loss can simply go limitless. If it plummets, the cost will still be significant but limited to the strike price excluding the net credit received from selling the contract.
For the strategy to reach its maximum potential, you want the stock to stay exactly the same at strike price A at the end of the contract, making it expired worthless. The call and put may be overvalued if implied volatility is unusually high for no apparent reason. Following the sale, the plan is to wait for volatility to fall before closing the position at a profit.
Unlike the two strategies mentioned above, the long strangle needs two values as strike prices when you are expecting a considerable fluctuation of the market price. During the setup, you buy a put at strike price A and a call at strike price B and hope for the highest state of volatility to hit the market.
The strategy profits when the stock price makes strong moves in either direction just like the long straddle. The difference between these two strategies is that you have two strike prices for the two legs of the trade. Both should be out-of-the-money, hence the reason why we need the high volatility and significant price changes before you can actually make profits.
Investors who are using the long straddle and the long strangle should be on their toes looking for major news events with the opportunities of making extraordinary market prices. If the news is big enough, your returns can go unlimitedly beyond the roof. In contrast, potential losses are manageable and limited to the net debit paid.
Like the short straddle, advanced traders should consider running this strategy when expecting the market price of the underlying stock is making almost no remarkable changes or experiencing a decrease in the implied volatility.
During the short strangle, you sell a put at strike price A and a call at strike price B. Generally, the stock price is expected to stay between these two points and ideally plateau out becoming worthless.
Just like the short straddle, if the stock price makes sudden sharp changes, you will inevitably be incurred with losses that can theoretically hit unlimited if the price fluctuation is positive. If the movements head downward, the defeat is still considerable but is now limited to the value of strike price A excluding the net credit received by selling the contract.
These strategies above are considered for experienced and seasoned traders already with years spent doing options trading. If you are just a fresher embarking on this new promised land, make sure you have a thorough understanding and careful preparation so that you can still know what should the situation turn against your favor. Remember to check out other guides on options trading. Stay tuned!