Strangle and Straddle Option Strategies Can Help with Volatility

The recent market volatility has pushed the major indexes to 52-week lows with huge bounce back rallies that have failed over the last few weeks. The whipsaw action can be costly if you are on the wrong side of an option trade but there are ways to help offset some of that volatility.

Two of the more popular option strategies traders use are straddle and strangle option trades. A straddle involves buying a call and a put on the same underlying asset, with the same strike price and same expiration date. A strangle also involves buying a call and a put, but with different strike prices. The call option has a higher strike, and the put option has a lower strike.

Both strategies are market-neutral and you’re looking for a stock to make a big move. However, you don’t care in which direction. High volatility increases the chance of a large price move and the reason straddles and strangles fit these types of market conditions. Another important point is that both are still a hedge on volatility but strangles are cheaper than straddles.

The cost basis and profit targets are simple to figure out. You profit if the price goes significantly above or below the strike price, you just need price action to move far enough to cover the cost of both options. You need a larger price move in the stock with a strangle than with a straddle, but you pay less upfront, so it’s a more cost-effective hedge on big swings.

Traders tend to use straddles when they are expecting high volatility and want to capture even moderate moves. Strangles are used when traders are expecting very high volatility, want to pay less, and believe the stock will move double-digits in either direction.

Both strategies are also popular for playing earnings announcements and clinical drug trials for just one or two days. These dates can be found on a lot of investing websites and profits and losses can come quick around these events.

As far as a sample straddle setup, let’s say a stock (or an index fund like QQQ’s) is trading at $100 and you think there is a chance for a 10% move, or more. If it’s an earnings event you could use weekly options, if available, and if it’s based on price action, you can use monthly options that expire in 30+ days.

If the price of the $100 call (strike price) is at $3 and the price of the $100 put (strike price) is at $2, the total cost for both options would be $5. The breakeven point to the upside would be at $105  – $100 (strike price), plus the $5 you paid in option premium. The downside breakeven point would be at $95 – $100 (strike price), minus the $5 you paid in option premium.

One of the profit scenarios for a double would be if shares are at $110 (by expiration) as the $100 call would be worth $10 (in-the-money). The puts would expire worthless, and the net credit would be the $10 in-the-money calls minus the $5 in premium. This gives you a $5 profit on $5.

The other profit scenario for a double would be if the stock drops to $90 (by expiration) as the $100 put (strike price) would be worth $10 (in-the-money). The calls would expire worthless, and the net credit would be the $10 in-the-money puts minus the $5 in premium. This also gets you a $5 profit on $5.

The risk to both strategies is if the price action is flat, or much less than expected.

If stock stays around $100, both options lose value. Overall, you could lose up to $5 total (max loss = premium paid). Some of the losses could be recouped depending on how far in-the-money call or put might be at the time of expiration.

The math formula for a strangle option trade on the same $100 stock is also easy to figure out but remember its cheaper.

If the price of the $105 call (strike price) is at $2 and the price of the $95 put (strike price) is at $1, the total cost for both options would be $3. The breakeven point to the upside would be at $108  – $100 (strike price), plus the $3 you paid in option premium. The downside breakeven point would be at $92 – $95 (strike price), minus the $3 you paid in option premium.

The first profit scenario for a double would be if shares are at $111 (by expiration) as the $105 call would be worth $6 (in-the-money). The puts would expire worthless, and the net credit would be the $6 in-the-money calls minus the $3 in premium. This gives you a $3 profit on $3.

The second profit scenario for a double would be if the stock drops to $89 (by expiration) as the $95 put (strike price) would be worth $6 (in-the-money). The calls would expire worthless, and the net credit would be the $6 in-the-money puts minus the $3 in premium. This also gets you a $3 profit on $3.

The risk of an strangle option trade is if the stock stays between $95 and $105 as both options would expire worthless. This means you would lose the entire $3 in premium for the max loss.

These positions are also known as “chicken trades” because a trader isn’t taking just one side of the trade as a vote of confidence in predicting price action. But as you can see, they can be very lucrative if you believe a stock is going to move 10+% over a certain time period.