Option Strategies - Part 4: Straddles and Strangles

Say you’re an options trader and forecast a sudden movement in a stock’s price, but you can’t decide if it’ll surge to record highs or plummet to all-time lows. With just the covered option, protective option, and spread strategies, an investor would have to choose to go either bull or bear on the stock price. What if there was a way to profit simply if the stock price substantially moves, regardless of its direction? In other words, is there a way to bet on nothing other than a stock’s high volatility? Welcome to the world of straddles and strangles.?

Long Straddle

A straddle simply involves buying a call and short option on the same underlying stock. This arrangement profits if the stock price moves either above or beneath the strike price. Here’s how it would work: say a stock is trading at $40 per share and you buy a call and a put option, each with a $40 strike price. Assuming each option cost $1, the total outlay and maximum theoretical loss would be $2.?

This suggests that the stock needs to rise or fall by 5% ($2 ÷ $40 = 5%) from $40 for the straddle to earn a profit, hence why the breakeven points are $38 and $42 in the graph below:

If the price exceeds $42, you can exercise the call option and ignore the put option. If the price drops below $38, you can exercise the put option and ignore the call option. The obvious downside is that the gains are reduced compared to what they would have been with just a long call or put strategy. If the stock rose to $43 and you held only the $40-strike-price call option, you would’ve profited $2 (accounting for the $1 premium). But because you purchased a put option for $1, you instead profit only $1 with the stock price at $43.?

There are a couple of other factors to consider when thinking about long straddles. Firstly, long straddles benefit from implied volatility. Referring to our part 2 on option greeks, a larger vega value (that is, greater sensitivity between the option’s price and implied volatility) results in higher option prices, and is therefore better for the long straddle position.?

The second is how the options’ theta, or time decay, would affect their value. As explained here, long options have a negative theta value because each passing day decreases the option’s value (remember, longer-dated options are worth more than shorter-dated ones because the more time left until expiration, the more opportunity there is for the underlying asset’s price to suddenly increase or decrease). Thus, theta is no friend of the long straddle. So ideally, the large stock price movement occurs quickly after the investor initiates the straddle, thereby presenting an opportunity to sell the options at a higher price and capitalize on their time value.

Short Straddle

While long straddles are put and call options simultaneously purchased, short straddles are put and call options simultaneously sold. Continuing with the long straddle example, if you sell an at the money, $40-strike-price call and put option for $1 each, your potential gains are confined to $2 (the total premium received) whereas your theoretical losses are unlimited (as is the case with individual short calls and puts).

This position will profit if the options expire when the stock price is between $38 and $42, as those earnings from the option buyer’s perspective are outweighed by the premiums you received for selling them. Within that price range, the options won’t be exercised and you’ll get to pocket the premiums. On the other hand, if the stock price rises above $42 or drops below $38, the total premiums no longer cover your losses, and so the short straddle position will yield a deficit.?

Similar to the long straddle, short straddles alter the payoff structure compared to selling just a put or call. If you sold a $1 put with a $40 strike price and the stock price dropped to $37, your net losses would amount to $2 (same goes for if you sold a $1, $40 strike price call and the stock price rises to $43). With a short straddle, however, you have additional premiums of $1 which offset your losses to, in this particular case, $1.?

Unlike long straddles, short straddles favor lower implied volatilities as they tend to result in lower option prices, which in turn suggest a lower likelihood of them being exercised. Higher theta values also work in support of the short straddle strategy, as the very passing of time decreases the option’s value. In such circumstances, the investor who sold the options could potentially buy back the options they sold and prevent them from ever unfavorably being exercised.

Long Strangle

The key difference between long straddles and strangles is that while the former requires buying options with the same strike price, the latter is all about simultaneously buying an out of the money put and out of the money call – in other words, with different strike prices (with the same expiration date). While long straddles and strangles are similar in that they’re both market-neutral (a kind that profits from both increasing and decreasing prices), strangles are far cheaper because you’re buying out of the money options. However, because the options’ strike prices are farther away from the spot price, long strangles require a more dramatic stock price movement to generate profit.

Here we have a call option with a $41 strike price and a put option with a $39 strike price, each purchased for $1. To profit, the stock price would have to drop below $37 or rise above $43 so that the put and call option, respectively, could be exercised. Anything in between that, and the net gains simply won’t exceed $2 (or the total amount you paid for both options).?

A $1 long call with a $41 strike price has a breakeven point of $42, and a $1 long put with a $39 strike price has a breakeven point of $38. Yet as seen in the graph, the additional dollar you paid for the other long option further stretches the long strangle breakeven points; you paid a total of $2 in premiums, and because the strike prices are a dollar below and above the $40 spot price, the breakeven “range” so to speak is from $37 ($40 - $3) to $43 ($40 + $3).?

Similar to long straddle, a long strangle holder would prefer higher implied volatility levels (as they increase the options’ value) and dread higher theta values (as they decrease the option’s value as time passes).

Short Strangle

The mirror opposite of long strangles; short, out of the money call and put positions opened in hopes that the stock won’t move very much. As is the case with most short option strategies, short strangles have limited potential profit (the premium received) and unlimited downside risk.

The reason you’d hope for minimal stock price movement is the same as the short straddle; for the $1, $39-strike-price put or $41-strike-price call to be profitably exercised, the stock price would have to move below $38 or above $42, respectively. But because you’ve earned a total of $2 in premium through the short strangle, the only points you have to worry about are $37 (the stock price moving below it) and $43 (the stock price moving above it). Remember, the premiums stretch your profitability range by an extra dollar on either side.?

As for the effects of implied volatility and theta values, they’re similar to the case of short straddles; a lowered implied volatility lowers options prices and therefore renders buying to close (buying back the previously sold options to limit losses) more feasible. A higher theta also lowers the option’s price and therefore also favorable to the short strangle strategy.

Econ IRL

In the research studying the fluidity of labor markets across countries, there is little attention paid to how these differences impact worker flows and behavior. This week’s paper seeks to quantify the consequences of these cross-country discrepancies in labor market fluidity on the workers’ careers (with “fluidity” being defined as how frequently workers make job-to-job transitions).?

The main empirical finding is that wages grow in more fluid labor markets, rising by 5-6% in years when a worker makes a job-to-job move. By controlling for education and occupation classifications across countries, the author concludes that this phenomenon cannot be driven by differences in worker composition.

‘Till next time,?

SoBasically