Straddle vs. Strangle Options Strategies

Views 15KJul 8, 2024

Options offer potential advantages and flexibility that can help some traders get a higher return on investment while managing risk — even if the market is trending downward.

But don’t dive in thinking it’s a sure thing. While the basics of selling covered calls and buying puts are a good place to start, you may need to branch out to more advanced strategies and expand your know-how to achieve your goals.

If you’re thinking of trying more advanced options trading strategies, you might begin with straddles and strangles.

Straddles and strangles are spread combinations some traders can use when expecting implied volatility (IV) to rise or a dramatic shift in price volatility.

Let’s look at these strategies and how you might use them to help build your portfolio!

A straddle and strangle options scenario

Consider a pharmaceutical company awaiting FDA approval for a new drug. Its stock price may fluctuate dramatically post-announcement.

A straddle involves purchasing both a call and put option at the same strike price and expiration date. For example, you purchase a call and put at a $50 strike price and expiry date of April 9, for $3 each. This strategy anticipates significant volatility regardless of direction. The cost of the straddle is the combined price of the put and call, which would be $6. Given the premium paid ($6), the stock would need to rise or fall by approximately 12% to potentially profit from this. To determine the required movement for profitability, you typically consider the premium paid relative to the current stock price, rather than the strike price.

Alternatively, a strangle would entail buying a call and a put at two different strike prices. Using the above scenario, an example would be an investor buying a $55 call and $45 option for $2 each. To potentially profit at expiration, the stock price will need to move above or below these amounts, by more than $4. Like straddles, they are considered directionally neutral, however, strangles allow investors who think a stock will move in a particular direction to add a directional bias to their strangle.

What is a straddle options strategy?

A straddle options strategy works similarly to how the name suggests. A trader uses both a call and a put with the same strike price and expiration date to straddle the strike price in anticipating a significant price change.

For instance, if Company X's current price is $50, a trader would purchase both a call and put at $50 with the same expiration date.

When selling a strangle, it's termed a short strangle and has a distinct theoretical maximum loss/gain.

A strangle involves selling both a call and a put option with different strike prices, typically out-of-the-money. When selling a strangle, it is indeed termed a short strangle. In this scenario, the potential gain is limited due to the premiums received from selling the options. However, the potential loss is theoretically unlimited because of the sale of the call option, which could lead to substantial losses if the stock price rises significantly.

Long straddle vs. short straddle:

A long straddle is when a trader buys a put and a call with the same strike price and expiration date.
A short straddle is when a trader sells both a put and a call at the same strike price and expiration date.

Long straddle

Theoretical loss potential: Limited to the combined amount paid for the put and call premiums.
Potential profits: For the call option, the stock could continue to rise in price, making potential profits unlimited until the expiration date. With the put option, profit is limited to the difference in the breakeven point and $0 because the price cannot fall below that amount.
Cost: Typically costs more than a long strangle and may increase in value if the stock price moves higher (because of the call option) or if it moves lower (because of the put option).

Short straddle

A trader might use a short straddle when they don’t expect the price of the underlying stock to move.

A short straddle is very advanced and traders using it are at a much higher risk.

Risk: Losses can be unlimited as traders selling contracts will be required to buy/sell the underlying asset if the contract owner exercises the option.
Potential profits: Max profit is the amount a trader makes from selling the contracts. This profit will be decreased by trading costs and if the price shifts at all.

What is a strangle options strategy?

With a strangle options strategy, a trader purchases an out-of-the-money (OTM) call and put with the same expiration date but different strike prices.

Both strangles and straddles are neutral strategies, agnostic to the direction of the underlying stock's movement. Some traders employ them when anticipating significant price movement but are uncertain about its direction. They can also capitalize on expected price changes while still hedging against adverse swings.

For instance, if Company X's current price is $50, a trader might buy a $45 call and a $55 put with an expiration date a month away, anticipating substantial movement without committing to a specific direction.

Long strangle vs. short strangle:

A long strangle is when a trader buys a put and a call with the same strike expiration date but different strike price.
A short strangle is when a trader sells both a put and a call with the same strike expiration date but different strike price.

Long strangle

Theoretical loss potential: Limited to the amount a trader pays for both premiums combined.
Potential gains: For the call option, the stock could rise in price significantly, leading to unlimited potential profits. With the put option, potential profit could increase as the price drops; it is limited by the underlying asset falling to $0.
Cost: A strangle strategy typically costs less than a straddle because the options are OTM, but also generally requires more movement in the underlying stock to potentially profit.

Short strangle

A trader might use a short strangle when they don’t expect the price of the underlying stock to move very much.

This strategy is very advanced and traders using it are at a much higher risk.

Risk: Losses can be unlimited as traders who write contracts will be required to buy/sell the underlying asset if the contract owner exercises the option.
Potential profits: Max profit is the amount a trader makes off the premiums of the contracts they sell. This profit will be decreased if the price shifts beyond the breakeven strike prices and by any trading costs.

Understand the difference between straddles and strangles

Both strangle and straddle options strategies are designed to help traders speculate on volatility while hedging against the risk of an unexpected market swing..

With either strategy, traders don’t need to know which way the market will swing. Instead, the straddles and strangles are designed to potentially profit from a swing in either direction.

Long straddles and strangles benefit more from larger price changes, while short straddles and strangles are more likely to be profitable when the underlying asset’s price holds steady or changes very little.

But this is where the similarities end.

STRADDLES	STRANGLES
Same strike price and expiration date for both the calls and puts.	Same expiration date but different strike prices: Put strike price will be lower than current market price. Call strike price will be higher than current market price.
Potential profits and value of the contracts generally change with any shift in the underlying asset’s price.	Requires a larger change in the underlying asset’s price for the options contracts to increase in value and potentially earn profits.
Cost more for the buyer. Seller receives higher premium.	Cost less for the buyer. Seller receives less premium.
Can be used with unknown direction of price change.	Can be used with both unknown and expected direction of price change.

Strangles Tips:

Traders typically purchase out-of-the-money (OTM) call and put options with the same expiration date but different strike prices.

This setup necessitates a substantial change in the underlying asset's price for the options contracts to appreciate in value and potentially generate profits. OTM options like these are commonly employed when traders anticipate significant price movement but are unsure about the direction.

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Straddle vs. strangle: Which is better for you?

When deciding between these two strategies, several factors should be considered, including how much you are willing to invest, your risk tolerance, and your expectations regarding the underlying asset's price movement.

A long straddle might be suitable for you if:

You are willing to commit more resources upfront to cover their higher premiums.
You anticipate significant price movement in the underlying asset and want to profit from either direction.
You can tolerate higher levels of risk, as straddles are generally more volatile.
The cost of the option contracts with identical strike prices is relatively balanced compared to other available strategies.

A long strangle might be preferable for you if:

You prefer to invest less upfront since they typically have lower initial costs.
You anticipate significant price movement in the underlying asset but are unsure about the direction.
You have a lower risk tolerance, as strangles tend to be less volatile.
The cost of the option contracts with different strike prices is more favorable relative to each other, offering a potential cost advantage.

Ultimately, determining the right strategy involves conducting an individual cost/benefit analysis based on your specific financial situation, risk tolerance, and expectations for the underlying asset's price movement.

Let’s look at an example of the potential costs between the two strategies below.

	Strike price	Expiration	Put premium	Call premium	Total cost	Breakeven point
Long straddle	$50	30 days	$2 x 100 shares	$2 x 100 shares	$400	+/- $4
Long strangle	$45/$55	30 days	$1 x 100 shares	$1 x 100 shares	$200	+/- $7

Important to remember: Short straddles and short strangles should only be used by experienced options traders. Both strategies involve much higher risk because of potentially unlimited losses.

Evaluating the risks of straddles and strangles

The risk factor for straddle and strangle options strategies depends both on which type of strategy you pick, as well as if you go long or short with that strategy.

Many traders might be tempted to go right for a straddle strategy because it can earn profit with less of a price change. However, straddles are often seen as riskier because they cost more and are more volatile.

In contrast, a strangle strategy tends to have a lower investment cost and a wider range before volatility can have an impact. Because of these considerations, a strangle options strategy tends to be less risky for beginner traders who have less experience and less capital.

Going long for less risk

The biggest impact on risk when it comes to advanced options strategies like straddles and strangles is going short.

When you sell any options contract, you have limited rewards because you only earn profit from the premium paid for the contract. However, you can face unlimited losses because you are required to buy/sell the underlying asset, no matter how much the price has changed.

Don’t forget: Short straddles and strangles have a limited maximum profit and unlimited loss potential!