Straddle strangle option strategies
Like a straddle , the options expire at the same time, but unlike a straddle, the options have different strike prices. A strangle can be less expensive than a straddle if the strike prices are out-of-the-money. The owner of a long strangle makes a profit if the underlying price moves far enough away from the current price, either above or below.
Thus, an investor may take a long strangle position if he thinks the underlying security is highly volatile , but does not know which direction it is going to move. This position is a limited risk, since the most a purchaser may lose is the cost of both options. At the same time, there is unlimited profit potential. We can see that after days, the strategy will be profitable only if the stock price is lower than approximately 80 dollars or higher than dollars.
These are the break-even points of the strategy. This is because options are losing value with time; this is known as time decay. The short strangle strategy requires the investor to simultaneously sell both a [call] and a [put] option on the same underlying security.
The strike price for the call and put contracts must be, respectively, above and below the current price of the underlying. The assumption of the investor the person selling the option is that, for the duration of the contract, the price of the underlying will remain below the call and above the put strike price.
If the investor's assumption is correct the party purchasing the option has no advantage in exercising the contracts so they expire worthless.
This expiration condition frees the investor from any contractual obligations and the money the premium he or she received at the time of the sale becomes profit. Importantly, if the investors assumptions are incorrect the strangle strategy leads to modest or unlimited loss. By buying both the call and the put, you are spending money, buying premium.
Your upside and downside profit potential are unlimited until stock reaches zero and your maximum loss is what you paid for the straddle. If you have bought a straddle near expiration, the time decay on the premium of the options will be extreme. Therefore, you will need stock to move either up or down beyond the price of the straddle to make money. A move up in implied volatility may or may not be enough to make up for the time decay.
You might buy a near term straddle before an event if you think the move in the stock, up or down, will be greater than the price of the straddle. With this strategy it is important to look at historical moves after events. For example if it is an earnings, you might look at the previous three or more earnings to see if the stock has moved beyond the price of the straddle following the announcement. Many times the average earnings move is priced already into the options.
You also generally would want to sell the straddle quickly after the event as implied volatility will generally come in. If you think stock will be moving around a lot over the duration of the life of the straddle you might buy with the expectation of scalping stock. As stock goes up the straddle will become a long delta position the call goes in-the-money, the put out-of-the-money and you can sell stock to stay delta neutral.
As the underlying moves down you become short deltas the put goes in-the-money and the call out-of-the -money and you would buy stock to be delta neutral. A long straddle further out will have less negative theta time decay and more positive vega. One might buy a long straddle a few months out if you think that volatility is trading especially low and that there could be stock movement or uncertainty occurring down the road that would cause implied volatility to go up.
To make a volatility determination, you might look at day historical volatility. Another consideration might be a year long graph of day implied volatility. If day implied volatility has not been below say 40 all year and you are buying lower than that then you might consider it low. You might look at where earnings and events fall in relation to the straddle and what implied volatility has done historically in relation to earnings and events.
You might consider the volatility of the underlying versus other similar underlyings or the market as a whole. You can see that even though a long straddle would seem to be a low risk strategy that it in fact requires a lot of consideration and precision of expectation in order to be profitable.
A short straddle, on the other hand, is a high risk position. As you can see from the graph that losses are unlimited and profits max at the price received for the sale of the straddle. Profits are only in the span of up or down the price of the straddle from the strike.