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Buying an option straddle or strangle is an often overlooked strategy that can have profit potential in either direction, with limited risk and unlimited profit potential. It may be just the right choice in market conditions where the trader expects a big move out of a trading range, but without directional expectations. While it may start out as a “neutral” strategy and be non-directional at the beginning, it will become directional and make gains if the market starts to trend as expected.
For the purpose of this discussion, we’ll discuss the “long” option straddle or strangle, which means buying the position. A long straddle or strangle has limited risk and unlimited profit potential, similar to an option backspread. In a “short” strategy, this involves un-hedged selling of options, and can have unlimited risk, with only limited profit potential.
The Option Straddle
A long option straddle position involves buying a call option and put option, with the same strike price and expiration month. So, you are literally “straddling” the market, able to take advantage of a move in either direction, because if the market moves up, the call will gain, and if the market moves down, the put will gain. This is a basic analysis, without considering the effect of time decay (theta) or change in option implied volatility (vega).
A typical example of an option straddle in Soybeans: In March, when option implied volatility is usually low and the market is often quiet, a trader might consider buying a straddle in September Soybeans. If Soybeans were trading around $6.00/bushel, a September straddle would buy the 600 call and put. This trade would have about 6 months until option expiration, plenty of time for a trend to develop, and would also be expected to benefit from a normal seasonal rise in option implied volatility. In some cases, if the market starts to get more volatile as the summer growing season approaches, a straddle trader might be able to take gains in one market direction, then take additional gains from a market reversal. Otherwise, in a case where the trader feels that a developing trend will continue, the losing option can be sold to recover some of the original trade cost, and the other option that is gaining in value and in line with the trend can be held.
The Option Strangle
The long option strangle varies only slightly from the straddle, and involves buying a call option and put option, using different strike prices, in the same expiration month. The most common strangle position uses out-of-the-money options, but there are variations called “guts” strategies using in-the-money options. Given the same market conditions at initiation, the strangle (using out-of-the-money options) will have a lower trade cost, but would normally require a larger market movement to be profitable.
Using the example of Soybeans again, if Soybeans are near $6.00 in the January-March period, an option strangle trade might involve buying the September Soybean 640 call and 560 put. Again, once the market starts to move, the strangle trader may decide to sell one of the options, either to take gains and trade a potential reversal, or to stick with a developing trend.
The best market conditions for initiating the option straddle or strangle:
Low option implied volatility, so that the trade can also benefit if option i.v. increases.
The expectation for a large move in the market, but without directional conviction. If the trade is initiated while the market is in a trading range, once a directional breakout is confirmed, the trader might consider only holding the option in line with the market direction.
The expectation, based in historical market performance, that the particular market will typically make moves of a magnitude that would generate profits above the entry cost, given the time until expiration. For example, if a straddle is bought with 4 months until expiration, and historical chart evaluation shows that the market will often move far enough in most 4-month periods to create gains for the trade, then that is an additional positive point when considering the position. In other words, you expect that the market can move far enough so that either the call or put will be worth more than the initial trade cost.
In most cases, allow at least 3 months to option expiration. This gives enough time for a significant move to occur, and also possibly for option implied volatility to cycle and increase. Sometimes, short-term straddles or strangles can be very effective, but the trader must be nimble and will usually drop the losing option once a directional move starts.
By giving more time to expiration when the trade is started, the trader will have the option of closing the trade early if market volatility doesn't occur as intended. This can significantly reduce potential losses, and new trades with more time can be started.
Chart example:
This chart shows profit/loss estimates at option expiration for a typical long option straddle. This involves buying an equal number of calls and puts, at the same strike, with the same expiration month. If option implied volatility is higher at the time of expiration, and the trade is in positive territory, gains can be higher (the effect of option vega).
The trade has unlimited profit potential on a rally or decline, with the maximum loss being the entry cost (the original premium paid for the call and put).
