Straddles and strangles are strategies option traders can use when they think a move in the underlying is imminent, but the direction is uncertain. Sounds like a can’t-lose plan, right? Well, obviously, if it were that easy, we would all be trading them, all the time. Let’s take a closer look.

Place Your Bets

With either strategy, the trader is betting on both sides of a trade by purchasing a put and a call simultaneously. An option strangle is generally just out-of-the-money (OTM), but with the same expiration. It is usually used when the underlying is between strike prices. An option straddle is when the underlying is trading at or close to a strike price and the same call and put strike are purchased with the same expiration.

Here’s the thing. By buying a put and a call that are OTM, an option trader pays a lower initial price than with an option straddle where the call and put purchased share the same strike price. However, this comes with a price (or risk). The stock will have to make a much larger move than if the option straddle were implemented because the breakeven points of the trade will be further out due to buying both options OTM, which is cheaper than buying at-the-money (ATM). The trader is, arguably, taking a larger risk (because a bigger move is needed than with an option straddle) but is paying a lower price. As with many trading strategies, there are pros and cons to each.

How They Work

To profit from an option straddle or strangle, a big move higher or lower is desired from the underlying as stated above. Generally, the position starts out with a neutral or close to delta neutral position. If the underlying moves higher, positive delta from the long call position takes over the position and the negative delta from the long put position starts to decrease. The opposite would happen if the underlying moved lower with negative delta leading the charge.

Determining Breakevens

An option strangle has two breakeven points just like the option straddle. To calculate these points, simply add the net premium (call premium + put premium) to the strike price of the call (for upside breakeven) and subtract the net premium from the put’s strike (to calculate downside breakeven). If at expiration the stock has advanced or dropped past one of these breakeven points, the profit potential of the strategy is unlimited (for upside moves). The position will take a 100% loss if the stock is trading between the put and call strikes upon expiration for a strangle and right at the strike price for a straddle. Remember that the maximum loss a trader can take on a strangle or straddle is the net premium paid.

The Enemy Is Theta

If you ever bought an option and the underlying did not move, you have seen negative theta in action. For a straddle or strangle, an option trader has two negative theta positions because of the long call and put. Time is of the essence on a straddle or strangle because the call and put premium is constantly eroding due to the passing of time. It goes without saying that an option trader prefers the underlying to move hard one way sooner than later for a straddle or strangle. To decrease negative theta, a farther expiration can be bought but that increases the overall risk and the breakeven points.

IV Can Go Either Way

The implied volatility (IV) of the options plays a key role in a straddle or strangle as well. With no short options in this spread, the IV exposure is all positive from the long call and put. Option premiums increase when IV rises. When IV is considered low compared with historical volatility (HV), it is a relatively “cheap” time to buy options. Since the option strangle involves buying a call and put, buying cheaper options is critical. If the IV is expected to increase after the option strangle is initiated, this could increase the option premiums with all other factors held constant, which is certainly a bonus for long option strangle holders. Of course, if IV decreases after the position is initiated, option premium will decrease similar to theta. You don’t want to have theta and vega working against you, but many times they do.

Final Thoughts

Unlike with a stock position, a trader cannot make money whichever way the stock goes. You have to be long or short and have the stock move higher or lower accordingly. An option straddle or strangle allows an option trader to not have a bias and still potentially make money. The key is to avoid taking a long time for the directional move to develop and keep IV from dropping a significant amount.

John Kmiecik, Market Taker Mentoring