Straddle and Strangle Option Strategies: A Comparison
There are many types of options strategies that can be employed depending on the investor’s view of the market and the underlying asset. Two of these strategies are straddle and strangle, which are similar in some aspects but differ in others.
What Is a Straddle?
A straddle is an options strategy that involves buying or selling both a call and a put option with the same strike price and expiration date. A long straddle involves buying both a call and a put, while a short straddle (if you can afford a big margin account) involves selling both a call and a put.
A long straddle is used when an investor expects a large price movement in either direction but is unsure of the direction. The investor profits if the underlying asset moves significantly above or below the strike price, enough to cover the cost of both options.
The maximum loss is limited to the total premium paid for both options, which occurs if the underlying asset stays at or near the strike price at expiration.
— — Lets understand this with a real example — —
Straddle Example with $QQQ Options:
Let’s break down a straddle strategy using the provided information:
Date of Option Purchase: 28th August 2023
Underlying Asset: $QQQ (an ETF that tracks the NASDAQ-100 Index)
Expiration Date of Options: 15th September 2023
Strategy: Long Straddle
Details:
- Buy a Call Option
- Strike Price: $364
- Expiration Date: 15th September 2023
2. Buy a Put Option
- Strike Price: $364
- Expiration Date: 15th September 2023
Maximum Loss: The maximum loss for a long straddle is the combined premium paid for both the call and the put options. In this example, the total premium paid (or the maximum loss) is $1,308.
Breakeven Points: For a long straddle, there are two breakeven points:
- Lower Breakeven = Strike Price of the Put — Combined Premiums
- 364–1,308/100 = 350.92
2. Upper Breakeven = Strike Price of the Call + Combined Premiums
- 364 + 1,308/100 = 377.08
So, for this straddle to be profitable at expiration:
- $QQQ needs to be trading below $350.92 or
- $QQQ needs to be trading above $377.08
If $QQQ is trading between these two prices at expiration, the straddle will result in a loss. The maximum loss of $1,308 occurs if $QQQ closes exactly at the strike price of $364 on the expiration date.
Conclusion: The long straddle strategy on $QQQ allows the investor to profit from a significant price move in either direction. Given the breakeven points, the investor is betting that there will be a substantial price movement away from the $364 level by the 15th of September 2023.
What Is a Strangle?
A strangle is an options strategy that involves buying or selling both a call and a put option with different strike prices but the same expiration date. The call option has a higher strike price than the put option, creating a gap between them. A long strangle involves buying both a call and a put, while a short strangle involves selling both a call and a put.
A long strangle is used when an investor expects a large price movement in either direction but is unsure of the direction. The investor profits if the underlying asset moves significantly above or below the strike prices of either option, enough to cover the cost of both options.
The maximum loss is limited to the total premium paid for both options, which occurs if the underlying asset stays within the range of the strike prices at expiration.
— — Lets understand this with a real example — —
Strangle Example with $QQQ Options
Let’s break down a strangle strategy using the provided information:
Underlying Asset: $QQQ (an ETF that tracks the NASDAQ-100 Index)
Date of Option Purchase: 28th August 2023
Expiration Date: 15th September 2023
Options Details:
- Call Option:
- Strike Price: $367
- Type: Long (Buying the call option)
2. Put Option:
- Strike Price: $361
- Type: Long (Buying the put option)
Maximum Loss: $1,030 (This is the total premium paid for both the call and put options combined.)
Breakeven Points:
- On the upside: $377.30 (This is calculated by adding the total premium to the call option’s strike price: $367 + $10.30)
- On the downside: $350.70 (This is calculated by subtracting the total premium from the put option’s strike price: $361 — $10.30)
Implied Volatility: 18.7% (This suggests the market’s expectation of how much the price of $QQQ will move over the next year. A higher implied volatility typically means higher option premiums, as the market expects greater price swings.)
Strategy Explanation:
In this strangle strategy, you are buying both a call and a put option on $QQQ. The goal is to profit from a significant price movement in either direction, but you’re not sure which way the price will move.
For you to profit:
- If $QQQ rises, it needs to move above the breakeven point of $377.30 before the expiration date.
- If $QQQ falls, it needs to drop below the breakeven point of $350.70 before the expiration date.
If $QQQ stays between these two breakeven points ($350.70 and $377.30) by the expiration date, you will incur a loss. The maximum loss you can face is the total premium paid for the options, which is $1,030.
The implied volatility of 18.7% suggests that the market expects a certain degree of price movement in $QQQ over the next year. This volatility can impact the premium of the options and, subsequently, the potential profitability of the strangle strategy.
The Difference
The main difference between straddle and strangle is the strike price of the options. A straddle involves buying or selling both a call and a put option with the same strike price, while a strangle involves buying or selling both a call and a put option with different strike prices.
A straddle is more expensive than a strangle, but it has a higher probability of profit. A strangle is cheaper than a straddle, but it requires a larger price movement to be profitable.
How to Read Volatility of Market
Volatility is a measure of how much an asset’s price fluctuates over time. It reflects the degree of uncertainty and risk in the market. Volatility can be measured using various methods, such as historical volatility, implied volatility, or volatility indices.
Historical volatility is calculated by using statistical formulas on past price data over a specific time period. It shows how much an asset’s price has deviated from its average in the past. Historical volatility can be used to analyze past trends and patterns, but it does not reflect future expectations.
Implied volatility is derived from option prices in the market. It shows how much volatility is expected by market participants in the future. Implied volatility can be used to gauge market sentiment and expectations, as well as to price options and other derivatives.
CBOE Volatility Index (VIX)
Volatility indices are indicators that track and measure volatility in different markets or segments. They are based on various methods and data sources, such as option prices, stock prices, or interest rates. One of the most popular volatility indices is the CBOE Volatility Index (VIX), which measures volatility in the S&P 500 Index (SPX).
The VIX is also known as “the fear index” because it tends to rise when investors are fearful and uncertain about market conditions, and fall when investors are confident and complacent. The VIX is calculated by using SPX index options with near-term expiration dates, and it generates a 30-day forward projection of volatility.
As a rule of thumb, VIX values greater than 30 are generally linked to large volatility resulting from increased uncertainty, risk, and investors’ fear. VIX values below 20 generally correspond to stable, stress-free periods in the markets.
Example of Values of VIX
The following table shows some historical values of the VIX and the corresponding market conditions and events that influenced them.
Conclusion
Straddle and strangle are both advanced options strategies that cater to investors with varying expectations of market volatility and price movement.
While they share similarities in their approach to capitalize on price fluctuations, their differences lie primarily in the strike prices of the options involved.
The choice between a straddle and a strangle depends on the investor’s market outlook, risk tolerance, and investment goals.
Furthermore, understanding market volatility, as measured by tools like the VIX, is crucial for investors employing these strategies. It provides insights into market sentiment and potential price swings, enabling investors to make more informed decisions.
As with all investment strategies, it’s essential to conduct thorough research and seek expert advice, when necessary, before diving into the complex world of options trading.
