Straddles and Strangles: Non-Directional Option Strategies

Straddles and strangles are nondirectional option strategies that can profit either from a significant market move, up or down, of the underlying security (aka underlier), or if the price of the underlier only moves sideways. When 1st set up, straddles and strangles are considered to be delta-neutral, because the positive delta of the call offsets the negative delta of the put. Delta is simply a measurement of the sensitivity of price changes of the options as the price of the underlier changes. So small changes in the price of the underlier do not significantly change the value of the nondirectional option position. Straddles and strangles are also considered to be volatility strategies, because the long positions profit when volatility is high, while the short positions profit when volatility is low.

Long straddles and strangles profit from significant market moves, while short straddles and strangles profit when the market meanders sideways. Long straddles and strangles have unlimited upside potential, but with limited risk, equal to the premium paid for the 2 options. Short straddles and strangles have a maximum profit equal to the premium received for selling both options. However, they have unlimited upside risk and considerable downside risk equal to the breakeven price of the underlier. The only reason to take the short position, with its unlimited risk and small profit potential, is when the market is expected to move sideways. Since a nondirectional market is more common than either a bull or a bear market, the short position is more likely to be profitable. Thus, the short position is only undertaken when profitability is deemed much more likely than the long position.

Straddles

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Option Payoff
The value received when exercising or selling an option.

A commonality of both short and long straddles is that both options of the straddle have the same:

Because both the call and the put have the same strike price, the options are at- or near-the-money when the straddle is bought or sold. However, a straddle can be set up with directional bias by choosing a strike price that is in the money for either the call or the put. Profits can also be earned if volatility is expected to increase enough so that the increase in the option prices because of increased volatility, measured by vega, more than offsets the decaying time value of the options, measured by theta.

A long straddle is established by buying the call and put, while a short straddle is set up by selling the call and put. Thus, whether a straddle is long or short depends on whether the options are long or short. The long straddle is chosen because the underlying price is expected to move sharply up or down, so the expiration date should be chosen so that it is after the expected price movement.

Straddles have 2 breakeven points: one on the upside and another on the downside. The upside breakeven point on a long straddle occurs when the price of the underlier equals the strike price plus the premiums of both options.

Upside Breakeven Price = Strike Price + Both Option Premiums

Downside Breakeven Price = Strike Price – Both Option Premiums

So if the strike price is $25 and the call and put premiums each cost $2, then the upside breakeven price of the underlier is equal to $25 + $2 + $2 = $29. The downside breakeven price is equal to the strike price minus the cost of the option premiums, so the downside underlier price in the above example is equal to $25 – $2 – $2 = $21.

Total profit is equal to the option payoff minus the breakeven price, so the long straddle profits when either the call or the put are in the money by more than the cost of both option premiums.

Total Potential Profit = Option Payoff – Both Option Premiums

So, in the above example, if the underlier reached $35 when the call is exercised, then the total profit will be equal to $35 minus the breakeven price of $29 for a total of $6 per share. If the price of the underlier goes to $18, then the put would be exercised. The long straddle holder would buy the stock in the open market for $18 per share, then sell the stock to the put writer for $25 per share, yielding a $7 per share payoff. After subtracting the $4 spent buying the put and the call, the remaining profit is $3 per share, which can also be found by simply subtracting the underlier price of $18 from the $21 breakeven price.

Long straddle losses may be less than the premium paid if one of the options is in the money at expiration.

The maximum loss is limited to the sum of the both option premiums, or the total debit. The maximum profit on the downside is limited to the downside breakeven price; there is no definite limit on upside profit.

  • Profit or Loss = Option Payoff – Total Debit
  • Downside Breakeven Price = Strike Price – Total Debit
  • Upside Breakeven Price = Strike Price + Total Debit

The maximum profit of a short straddle is limited to the credit received for selling the options, but maximum losses have no definite limit. Indeed, Nick Leeson, a rogue trader, bankrupted Barings bank, Britain's oldest merchant bank, partly by selling short straddles on the Nikkei index, betting that the Nikkei index was going to meander sideways. Why even sell short straddles if potential losses can be much greater than profits? Because directionless markets are more common than bull or bear markets, so a directionless market strategy will pay off more often than not.

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A short straddle is chosen when the price of the underlier is expected to hover around the strike price of the call and put. The maximum profit of the credit received on selling the 2 options is earned when both options expire worthless.

  • Profit or Loss = Total Credit – Exercised Option Value
    • Exercised Call Option Value = Stock Price – Strike Price
    • Exercised Put Option Value = Strike Price – Stock Price
  • Downside Breakeven Price = Strike Price – Total Credit
  • Upside Breakeven Price = Strike Price + Total Credit
Example: Long and Short Straddle for Apple, Inc. on July 1, 2014
Stock Price$93.79
Long Straddle
August, 2014 OptionsStrikePrice
Put95$2.83
Call95$6.20

Total Debit$9.03
Maximum Loss$9.03=Total Debit
Maximum Profit on Downside$85.97= Lower Breakeven Price
Maximum Profit on UpsideNo Definite Limit
Upper Breakeven Price$104.03= Call Strike + Total Debit
Lower Breakeven Price$85.97= Put Strike – Total Debit
Below is a line chart showing the potential profit/loss of a long straddle for Apple Corporation at options expiration for underlying stock prices of $70 to $120.
Short Straddle
Put95$2.83
Call95$6.20

Total Credit$9.03
Maximum Profit$9.03
Maximum Loss on Downside$85.97= Lower Breakeven Price
Maximum Loss on UpsideNo Definite Limit
Upper Breakeven Price$104.03= Call Strike + Total Credit
Lower Breakeven Price$85.97= Put Strike – Total Credit
The potential profit/loss of a short straddle for Apple Corporation at options expiration for underlying stock prices of $70 to $120.

Strangles

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A long strangle and short strangle are the same as a long straddle and short straddle, with the same underlying security and expiration dates, except the call and put are out-of-the-money, so they must have different strike prices. Instead of the strike price being at or near the price of the underlier, as is usually the case with the straddle, the call has a higher strike price than the price of the underlier, while the put has a lower strike price than the price of the underlier.

The risk/reward attributes of straddles also apply to strangles. However, because the options are out-of-the-money, a long strangle will be less likely to be profitable and whatever profits are earned will be less than for a long straddle. For the short strangle, the maximum profit will be less because out-of-the-money options are sold, yielding less of a premium to the seller. Although the upside/downside risk profile of a short strangle is the same as for a short straddle, risk is lower because the price of the underlier would have to move further in either direction before losses are incurred.

The graphs of the 2 straddles and strangles are similar, except that the graphs of the strangles have a flat top or bottom equal to the difference in strike prices, whereas the maximum loss in a long straddle or the maximum profit in a short straddle meet at a point.

Example: Long and Short Strangle for Apple, Inc. on July 1, 2014
Stock Price93.79
Long Strangle
August, 2014 OptionsStrikePrice
Put901.81
Call952.83

Total Debit4.64
Maximum Loss4.64=Total Debit
Maximum Profit on Downside85.36= Lower Breakeven Price
Maximum Profit on UpsideNo Definite Limit
Upper Breakeven Price99.64= Call Strike + Total Debit
Lower Breakeven Price85.36= Put Strike – Total Debit
The potential profit/loss of a long strangle for Apple Corporation at options expiration for underlying stock prices of $75 to $115.
Short Strangle
Put901.81
Call952.83

Total Credit4.64
Maximum Profit4.64= Total Credit
Maximum Loss on Downside85.36= Lower Breakeven Price
Maximum Loss on UpsideNo Definite Limit
Upper Breakeven Price99.64= Call Strike + Total Credit
Lower Breakeven Price85.36= Put Strike – Total Credit
The potential profit/loss of a short strangle for Apple Corporation at options expiration for underlying stock prices of $75 to $115.

Compare profits and losses for the short and long strangle: