Options Strategies- The 3’S (Strangles, Straddles, and Spreads)

Hello LinkedIn Community!

Let’s learn about Straddles, Strangles, and Spreads: Understanding the building blocks of advanced options strategies.

Straddle and Strangle are two types of "Combination option strategies". However, there is a difference between both strategies:

1. Straddle strategy: In a straddle strategy, the investor buys a European call and put options with the same strike price and expiration date. The strike price acts as a mid- point for the strategy and if the price of the underlying asset is closer to this strike price, the straddle strategy leads to a loss. However, if the price of the underlying asset moves significantly in either direction from the strike price, the strategy leads to a significant profit.

The payoff from the strategy:

• If ST ≤ K1: The long call option will be worthless, however, the long-put option will be profitable and the final payoff will be K1 -ST.
• If ST > K1: The long call option will be profitable, however, the long-put option will be worthless and the final payoff will be ST – K1.

Hence, the closer the price of the underlying asset gets to the strike price the profits tend to decrease.

2. Strangle strategy: In a strangle strategy, the investor buys a European put option and a European call option with the same expiration date and different strike prices. Here, the call strike price of K2 is higher than the put strike price of K1. The idea behind strangle strategy is the same as the straddle strategy in that the price should be farther than the strike price however if we compare the straddle strategy with this one, the key difference is that the price should move substantially farther than what was seen in the straddle strategy in order to make a profit.

However, the downside risk of the price being at the central value is less in the strangle strategy. Profit is determined as per the difference between the strike prices and the underlying stock’s price movement in a particular direction. The more the strike prices are away from each other, the less the chance of a downside risk to occur but the more the price must move to realize a certain profit.

The payoff from the strategy:

• If ST ≤ K1: In this case, the call option will not be exercised and will remain worthless but the long put will be profitable and the final payoff will be K1 - ST.
• If K1 < ST < K2: In this case, both the options will remain worthless, and the investor will lose the premium paid.
• If K2 ≤ ST: in this case, the long call option will be profitable, however, the long put option will not be exercised and will remain worthless and the final payoff will be ST – K2.

Spreads are trading tactics that include buying and selling two or more options of the same type (either calls or puts) on the same underlying asset but with varying strike prices, expiration dates, or both.

An investor who enters into a Bear spread hopes that the prices will decline. There are two ways by which bear spread can be created:

1. Call Bear Spread: In a bear call spread, one call option is sold and another, with the same expiration date but a higher strike price, is purchased. When the value of the underlying asset remains below the lower strike price at expiration, this approach is profitable.

Method:

• Sell a call option with a strike price of K1 at a specific expiration date. You are hoping that theprice of the underlying asset will stay below the strike price.
• Simultaneously, buy a call option with strike price K2 where K2 > K1. Doing this will help you if the price of the underlying asset crosses the strike price K1 because it will prevent you from having substantial losses as the price goes above.

Outcome:

If the price of the underlying asset stays below the strike price K1, the first option (sell) will not be exercised and you will keep the premium as your profit. However, if the price of the underlying asset crosses the strike price K1, your losses will be covered with the profits you will receive with the long call option.

2. Put Bear Spread: In a bear put spread, one put option is purchased and another put option with a lower strike price and the same expiration date is sold. The underlying asset's price drops below the higher strike price at expiration, which is when this approach is profitable.

Method:

• Buy a put option with a strike price of K1 at a specific expiration date. Here, you are hoping that the price of the underlying asset will stay below the strike price.
• Simultaneously, sell a put option with a strike price of K2, where K1 > K2. Doing this will help you to offset the cost of purchasing the previous option.

Outcome:

If the price of the underlying asset stays below the strike price of K1, you will have profits from both options. Profit will depend on the difference between the strike prices and the initial cost to acquire the options. However, if the price of the underlying asset goes above K1, you will just lose the premium paid to acquire the options.

A Bull spread is a strategy in options trading meant to make a profit from an increase in the price of the underlying asset. Like the bear spread strategy, there are two ways to create a bull spread:

1. Call Bull Spread: Call Bull spread is an optimistic option strategy, as it involves purchasing and selling call options to take advantage of an anticipated increase in price movement.

Method:

• You buy a call option with a lower strike price, K1, at a specific expiration date. This means you believe the price of the underlying asset will go above this strike price.
• At the same time, you sell a call option with a higher strike price, K2, where K2 > K1. This helps cover the cost of the bought call and sets a cap on the maximum profit.

Outcome:

• If the price of the underlying asset surpasses the lower strike price, K1, the purchased call option will increase in value.
• The perfect situation is when the price of the asset ends up closing at or above the higher strike price K2 when the option expires. If this happens, you make a profit which is the difference between the two strike prices minus the premium paid. If the price of the asset stays between K1 and K2, you will make a partial profit. However, if the price remains below K1, both options expire without value, resulting in a loss of the initial premium paid for the strategy.

2. Put Bull Spread: Put Bull Spread aims to take advantage of a rise in the value of the asset, much like the call bull spread. However, in this case, it utilizes put options to achieve its objective.

Method:

• Purchase a put option with a higher strike price (K1) that expires on a specific date. This is based on the belief that the price of the underlying asset will not drop to this level.
• At the same time, you can also sell a put option with a lower strike price K2, where K1 > K2. This will help lower the cost of the spread and set a limit on the maximum potential loss.

Outcome:

• If the price of the underlying asset stays above the higher strike price K1, the put options will expire worthless. In this case, you will benefit from the premium received for selling the put option at strike price K2. The most profit will be made if the price remains above K1.

If the price falls between the two strike prices, there will be a partial profit or loss depending on the asset's price at expiration. If the price drops below K2, the maximum loss will be the difference between the two strike prices minus the net premium received when establishing the spread.

(Note: ST - Stock Price at Expiration, K1 - Strike Price 1, K2 - Strike Price 2)

Thank you for reading! I appreciate your interest in these advanced options strategies and would love to hear your thoughts and experiences with them.