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 deemed 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 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
- 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:
- underlying asset
- expiration
- strike price
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 = $25 + $2 + $2 = $29. The downside breakeven price = the strike price minus the cost of the option premiums, so the downside underlier price in the above example = $25 − $2 − $2 = $21.
Total profit = 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 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 will meander sideways. Why even sell short straddles if potential losses may greatly exceed profits? Because directionless markets are more common than bull or bear markets, so a directionless market strategy will pay off more often than not.
Stock Price | $93.79 | |
Long Straddle | ||
---|---|---|
August, 2014 Options | Strike | Price |
Put | 95 | $2.83 |
Call | 95 | $6.20 |
Total Debit | $9.03 | |
Maximum Loss | $9.03 | =Total Debit |
Maximum Profit on Downside | $85.97 | = Lower Breakeven Price |
Maximum Profit on Upside | No Definite Limit | |
Upper Breakeven Price | $104.03 | = Call Strike + Total Debit |
Lower Breakeven Price | $85.97 | = Put Strike − Total Debit |
Short Straddle | ||
Put | 95 | $2.83 |
Call | 95 | $6.20 |
Total Credit | $9.03 | |
Maximum Profit | $9.03 | |
Maximum Loss on Downside | $85.97 | = Lower Breakeven Price |
Maximum Loss on Upside | No Definite Limit | |
Upper Breakeven Price | $104.03 | = Call Strike + Total Credit |
Lower Breakeven Price | $85.97 | = Put Strike − Total Credit |
Strangles
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 must move further in either direction before losses are incurred.
Stock Price | 93.79 | |
Long Strangle | ||
---|---|---|
August, 2014 Options | Strike | Price |
Put | 90 | 1.81 |
Call | 95 | 2.83 |
Total Debit | 4.64 | |
Maximum Loss | 4.64 | =Total Debit |
Maximum Profit on Downside | 85.36 | = Lower Breakeven Price |
Maximum Profit on Upside | No Definite Limit | |
Upper Breakeven Price | 99.64 | = Call Strike + Total Debit |
Lower Breakeven Price | 85.36 | = Put Strike − Total Debit |
Short Strangle | ||
Put | 90 | 1.81 |
Call | 95 | 2.83 |
Total Credit | 4.64 | |
Maximum Profit | 4.64 | = Total Credit |
Maximum Loss on Downside | 85.36 | = Lower Breakeven Price |
Maximum Loss on Upside | No Definite Limit | |
Upper Breakeven Price | 99.64 | = Call Strike + Total Credit |
Lower Breakeven Price | 85.36 | = Put Strike − Total Credit |
Compare profits and losses for the short and long strangle:
- The maximum profit for the short position is the same as the maximum loss for the long position
- The maximum loss on the downside and the upside for the short position is the same as the maximum profit for the long position.
- Note, from the 1st Apple example using straddles, that the maximum profit for the short straddle and maximum loss for the long straddle is greater then the maximums for the respective strangles, because at least 1 of the straddle options will be in the money or both will be at the money.