Straddle and strangle strategy

What is a straddle options strategy?

Definition of a straddle options strategy

A straddle options strategy involves buying or selling a call and a put option on the same underlying asset, with the same strike price and expiration date. The aim is to profit from significant price movements in either direction.

A straddle is made up of two components:

• The call option gives the right to buy the asset at the strike price
• The put option gives the right to sell the asset at the strike price.

Long straddle

In a long straddle, the trader buys both the call and the put option. They might do this when they expect a major price move but aren’t sure which direction it’s going to go (e.g. ahead of earnings reports or economic announcements).

Here’s how a long straddle works:

• Both options are purchased at the same strike price and expiration
• The trader profits if the price moves in either direction
• The break-even points are the strike price plus and minus the total cost of the options (i.e. combined premium paid).

The maximum risk is limited to the total premium paid and the maximum profit is theoretically unlimited if the market moves far enough.

Short straddle

In a short straddle, the trader sells both the call and put at the same strike price and expiration. They might do this when they expect the market to stay relatively flat.

Here’s how a short straddle works:

• The trader collects premiums for both options upfront
• The profit is maximized if the price stays near the strike price at expiration
• The break-even points are the same as in a long straddle (the strike price plus and minus the total premium collected).

The maximum profit in a short straddle is limited to the premiums received, but the potential loss is unlimited on the upside (due to the short call) and significant on the downside (due to the short put).

What is a strangle options strategy?

Definition of a strangle options strategy

Like a straddle, a strangle options strategy aims to profit from large price moves in either direction. It also involves buying or selling a call and a put with the same expiration date and underlying asset, only this time with different strike prices – above the current market price for calls and below the current market price for pulls (i.e. both are out-of-the-money).

Because the trader is ‘strangling’ the current market price with two strike prices (one above and one below), this strategy gives a wide net to capture profits whether the asset’s price rises or falls.

Long strangle

In a long strangle, traders buy an out-of-the-money call option (strike price above current market price) and out-of-the-money put option (strike price below market price), both with the same expiration date.

This strategy is best used ahead of major announcements (e.g. earnings reports or Fed decisions) or when traders expect higher volatility but aren’t sure whether the asset will go up or down. The maximum loss is limited to the total premium paid and the profit potential is theoretically unlimited on the upside, and significant on the downside. The breakeven points are the strike prices plus and minus the combined premium paid.

Short strangle

In a short strangle, the trader sells an out-of-the-money call and out-of-the-money put with the same expiration dates. This strategy profits when the asset’s price stays within a certain range and both options expire worthless.

Short strangles are best used when the market is expected to remain stable or the trader wants to collect premium income and is willing to accept higher risk (and has a clear risk-management strategy in place). The maximum profit is limited to the premiums received and potential loss is unlimited if the price moves outside the strike range.

Note that large price moves in either direction can lead to significant losses with a short strangle, so strict risk controls are essential.

Straddle vs. strangle: What are the differences?

Both straddles and strangles involve using calls and puts to profit from large price movements in either direction, but the similarities end there. Here’s how the two options strategies differ:

Setup and components

The main difference between a straddle and strangle is the strike price:

• A straddle uses at-the-money options, meaning the trader buys or sells a call and a put with the same strike price, which matches the current market price of the asset.
• A strangle uses out-of-the-money options, which means the call has a higher strike price than the asset’s market price and the put has a lower strike price.

This means that straddles tend to have a narrower profit range but respond more quickly to stock price movements, while strangles need a larger move to be profitable.

Risk and reward

Long straddles profit when the asset price moves significantly in either direction beyond the combined premium cost. Losses are limited to the premium paid, but profit potential is unlimited. Short straddles earn a premium if the asset price remains near the strike, however they carry unlimited risk if the price swings sharply.

The same rules apply to long and short strangles, except since the strike prices are further apart, the break-even points are wider. This means the risk/reward profiles are slightly more conservative.

Cost

Cost is another major difference between the two. Straddles typically cost more upfront, since at-the-money options have higher premiums. Strangles are less expensive because out-of-the-money options are cheaper. However, they require more movement in the underlying stock price to be profitable.

To put it simply, straddles cost more but respond faster to volatility while strangles cost less but need bigger moves to pay off.

Advantages and disadvantages of straddles and strangles

Like any trading strategy, straddles and strangles have their own advantages and drawbacks.

Straddle pros and cons

Some of the pros of a straddle strategy are:

• Flexibility: Straddles can be used in various market conditions, including volatility expansions, contractions, or even sideways movements.
• Hedging: Straddles can be used as a hedging tool when traders expect volatility but aren’t sure in which direction. By purchasing both calls and puts, they keep both sides of the market covered.
• Defined risk: The maximum loss with a long straddle is limited to the total premium paid, which can help traders manage risk effectively. Short straddles, however, have unlimited risk potential.

Some of the cons of a straddle strategy are:

• Costs: Long straddles can be expensive as they require buying both calls and puts at-the-money. The asset needs to move significantly to cover the combined premium and become profitable, otherwise the position will incur a loss.
• Time decay: Time decay can reduce the value of calls and puts in a long straddle, however it can actually be beneficial for a short straddle if the asset stays near the strike price.
• Unlimited risk: If the asset breaks out sharply, short straddles can lead to significant losses on either side.
• Limited profit potential: Because assets need to make a substantial price movement, long straddles often have a lower chance of success.

Strangle pros and cons

Some of the pros of a strangle strategy include:

• Lower cost: Strangles are generally cheaper to set up than straddles since both options are out-of-the-money.
• Profit from big moves: Long strangles have unlimited upside potential and can profit from large price swings in either direction.
• Customizable risk: Traders can adjust strike distances to reflect their market view or reduce costs. The wider the strikes, the cheaper the setup (but also the more the asset needs to move).

Some of the cons of a strangle strategy include:

• Needs big price moves: The asset’s price needs to move sharply and quickly to exceed the combined premium paid.
• Time decay: For long strangles, if the expected move doesn’t happen quickly, the value of both options decays and reduces profit potential.
• Unlimited risk: Like short straddles, short strangles have theoretically unlimited risk if the asset makes a strong move up or down.

Calculating break evens

Straddles and strangles have two breakeven points because they’re dealing with two options:

• The upper breakeven point is the price above which the call option starts making money after covering the total premium
• The lower breakeven is the price below which the put option starts making money after covering the total premium.

Calculating break evens for a long straddle

The breakevens for a long straddle are:

• Upper breakeven = Strike Price + Total Premium Paid
• Lower breakeven = Strike Price - Total Premium Paid.

Calculating break evens for a short straddle

The breakevens for a short straddle are:

• Upper breakeven = Strike Price + Total Premium Received
• Lower breakeven = Strike Price - Total Premium Received.

Calculating break evens for a long strangle

The breakevens for a long strangle are:

• Upper breakeven = Call Strike Price + Total Premium Paid
• Lower breakeven = Put Strike Price - Total Premium Paid

Calculating break evens for a short strangle

The breakevens for a short strangle are:

• Upper breakeven = Call Strike Price + Total Premium Received
• Lower breakeven = Put Strike Price - Total Premium Received

Real-world examples

Let’s go through some real-world examples to help you understand how straddles and strangles work.

Long straddle example

Imagine that a trader believes stock ABC, currently trading at $75 per share, is about to experience significant volatility with an upcoming product launch. The trader wants to capitalize on this movement and decides to implement a long straddle strategy, buying a call and a put option, both with a strike price of $75 and $4.50 premium. The total cost is the combined premium of $9.00.

The breakeven points are:

• Upper breakeven = $75 + $9 = $84
• Lower breakeven = $75 - $9 = $66

If the stock jumps to $90, the call option becomes worth $15 while the put expires worthless. The trader makes a $6 profit ($15 - $9 premium).

If the stock price drops to $65, the put becomes worth $10, while the call expires worthless. The profit is $1 after accounting for the premium.

Short straddle example

Let’s say a trader expects stock ABC, currently trading at $60 per share, to trade in a range-bound fashion for the next month. The trader enters a short straddle, selling both a call and a put, each with a strike of $60 and premium of $2.80. The total premium received totals $5.60.

The breakeven points are:

• Upper breakeven = $60 + $5.60 = $65.60
• Lower breakeven = $60 - $5.60 = $54.40

If stock ABC stays between $54.40 and $65.60 until expiration, the trader makes a profit up to the full premium collected. The maximum profit is $5.60 if the stock expires at exactly $60.

But if the stock price rises to $70 or drops to $50, the trader faces unlimited potential losses due to the short call or put.

Long strangle example

Imagine that a trader expects stock ABC, currently trading at $40 per share, to make a big price movement but they're not sure in which direction. They set up a long strangle by buying a $44 call for $2.20 and a $36 put for $2.80. The total premium paid is $5.00.

The breakeven points are:

• Upper breakeven = $44 + $5 = $49
• Lower breakeven = $36 - $5 = $31

If stock ABC jumps to $52, the call is worth $8 and the trader earns a $3 profit. If the stock drops to $30, the put is worth $6 and the trader earns a $1 profit. If the stock stays around $40, both options lose value and the trader loses the premium paid.

Short strangle example

Now imagine a trader expecting stock ABC, currently trading at $40 per share, to remain stable. They take a short strangle strategy, selling one $44 call for $2.20 and one $36 put for $2.80. The total premium received is $5.00.

The breakeven points are:

• Upper breakeven = $44 + $5 = $49
• Lower breakeven = $36 - $5 = $31

If the stock stays between $36 and $44, the options expire worthless and the trader keeps the $5 profit. If it jumps to $52 or drops to $30, losses are theoretically unlimited.