Editor’s note: A recent article introduced basic call and put strategies—selling covered calls for potential income and buying puts for downside protection. This follow-up article looks at buying straddles and strangles combinations for the option trader who’s expecting a stock to move significantly in one direction or the other, but not certain which way.
Perhaps there’s an earnings report coming up in a stock you’re considering. Or maybe there’s a product launch on tap, and you think it’s either going to be revolutionary…or a colossal flop. One way or the other, you believe price volatility is on the way.
Buying a straddle—a call and a put of the same strike and same expiration date—or a strangle—an out-of-the-money (OTM) call and put of the same expiration date but different strikes—can help you get that volatility exposure.
Straddles and strangles are considered “directionally agnostic,” meaning it’s about the magnitude of a move, not the direction. When you buy an at-the-money (ATM) straddle, it has a net delta of zero since the .50 delta of the call is offset by the -.50 delta of the put. So a significant move up in the price of the underlying, all else equal, should have roughly the same effect on the theoretical value (TV) of the straddle as an equivalent down move in the price of the underlying.
The same can be said for the purchase of a strangle made up of equivalent delta options (such as a .20 delta call and a -.20 delta put). Up or down, a big move is a big move. (And for more on delta and other “option greeks” have a look at this primer.)
“But,” you say, “if the stock price goes up, my call goes up in price, but the put loses value.” True. But that’s where magnitude comes in. As a stock price continues in one direction, the in-the-money option leg should keep rising in value—eventually moving one-to-one with the underlying (the exception being if high volatility is already priced into the option premium), while the OTM leg approaches zero, but can go no lower. To illustrate look at the straddle and strangle profit/loss graphs in figure 1.
FIGURE 1: STRADDLE AND STRANGLE RISK GRAPHS.
With underlying stock at $60, the image on the left is the 60-strike straddle. The image on the right is a strangle made up of the 55-strike put and 65-strike call (the “55-65 strangle”). For illustrative purposes only.
Choosing a Strategy
So, which should you choose, the straddle or the strangle? The answer, as is often the case with option strategies, it depends on your objectives and risk tolerance. In general, a straddle will cost more, but its TV begins rising as soon as you move away from the strike price. Conversely, the strangle is generally less expensive to buy, as its legs consist of OTM options, but the strangle doesn’t pick up steam until the underlying gets to one of the two strikes.
Let’s look at an example.
Using the 70-strike option prices in Table 1, you could buy the straddle for $2.80 ($1.40 for the call, and $1.40 for the put), plus transaction costs. At expiration, if the stock is either higher or lower than $70 by more than $2.80, then the straddle would in theory be a winner. A strangle example could be the 68 put and the 72 call. Buying the strangle would cost $1.40—half of what the straddle cost (again, plus transaction costs.) With this lower cost, though, comes the need for the stock to move more to make the strangle profitable. At expiration, the stock would need to be below $66.60 ($68 – $1.40) or higher than $73.40 ($72 + $1.40). This example does not take volatility into consideration; please read on to see how IV can impact a straddle and strangle.
|Stock Price = $70||Call Bid||Call Ask||Strike||Put Bid||Put Ask|
|25 days til expiration||2.65||2.80||68||0.65||0.75|
Table 1: Example Option Chain. Theoretical prices for options with 25 days until expiration. For illustrative purposes only. And remember the multiplier. For these examples, remember to multiply the option premium by 100, the multiplier for standard U.S. equity option contracts. So an option premium of $1 is really $100 per contract.
Assessing the Risks
Options don’t need to be held through expiration. Many traders will look to close their straddle or strangle once the date of the anticipated move has passed. By owning a straddle or strangle, you have two options that are subject to time decay (“theta”) which is the natural daily erosion of option prices.
One risk of buying a straddle or strangle is that the magnitude of price movement in the underlying stock may not be enough to compensate for the theta. And the higher the implied volatility (IV) as you enter the trade, the higher the entry point for your straddle or strangle, and thus the greater the price move you may need to see in the underlying before you are able to break even.
How can you determine whether a stock’s IV is high or low? One way is to use the IV percentile, available to TD Ameritrade clients in the thinkorswim® platform. The IV percentile indicator compares the current implied volatility (IV) to its 52-week high and low values. See figure 2.
FIGURE 2: ALL IN THE VOL.
Use today’s options statistics, such as the current IV percentile, to help you determine whether to consider purchasing a straddle or strangle. Image source: thinkorswim platform from TD Ameritrade