Straddle and Strangle are both options strategies that help an investor make a profit. These strategies are suggested/recommended when the trader and the investor are not sure about the direction of the price movement. We also call both these strategies as non-directional option strategies. This is because investors resort to such a strategy when they don’t have any view on the direction that the price of the security would move. Before we proceed further and see when such strategies can be used, we need to understand the difference between Straddle vs Strangle.
Usual strategies in futures and options generally follow the investor outlook of the market/security and thus take a bullish or bearish stand on the price movement. In case an investor doesn’t have any view on the market, they bet on how less or more volatile the market is. Such strategies of betting on the volatility are volatile strategies. Straddle and Strangle are the two most popular volatile strategies.
In both these strategies, an investor buys the same number of call and put options. And options are traded having the same expiry dates. However, the key difference in the strategies lies in the selection of strike price. In strangle, the call and put options are traded at two different strike prices. On the other hand, a straddle has a common strike price.
Now as we know the basic difference between Straddle vs Strangle, let’s take a look at other differences between Straddle vs. Strangle.
Straddle vs Strangle – Difference
Following are the differences between Straddle and Strangle:
When to Use?
An investor usually goes for straddle when they have no idea on the direction that a price may move. On the other hand, strangle is when an investor believes there are more chances of a price moving in one direction, but still wants protection in case of adverse movement.
Straddle trade usually cost more than strangle. Moreover, the investor requires less of price movement to break even in case of strangle.
In a straddle, an investor goes for the call and puts option that is “at-the-money.” On the other hand, in strangle, an investor goes for the call and put option that is “out-of-the-money.” Due to this, strangle strategy costs less than the straddle position.
Example of Straddle
Suppose Company A will report its earnings report in about three weeks. Investor B, however, has no idea if the report will be good or bad. So, the investor goes for the straddle to benefit from the price movement when the earnings report come out.
Company A’s stock is currently trading at $30. Now assume the price of $30 call and put option of three months from now is $4 and $2, respectively. Now the cost of straddle will be ($4 + $2)
If the earnings report is good and stock moves up, the straddle’s value will also go up due to the long call option. Also, the straddle’s value will rise (thanks to the long put option) even if the share price goes down. Investor B will continue to realize gain if the stock price movement in either direction is more than $6 (covering the cost of straddle).
Suppose after three months, the stock price of Company A is $40. Now, Investor B would use the call option and the put option would get useless. Using the call option, Investor B would buy the share at the strike price of $30, and then sell it at the current market price of $40.
Net profit for Investor B in this case will be $4 ($40 – $30 – $6).
Same will be the case if the share price of Company A trade at $20 after three months.
Example of Strangle
Suppose Investor B expects Company A to report a good earnings report. This means the investor needs less downside protection. So, rather than buying a put of $30 at $2, Investor A buys a put option with a strike price of $25 at a price of $1, and call option of $30 at a price of $4.
In this way, the investor gets protection from extreme downside, while also putting him a better position to benefit from the price rise.
Now, if the stock price remains the same after three months, both call and put option will expire worthless. The total loss will be price of the call and put option, i.e. $5.
Now, if the stock price after three months is $40, the put option will become useless. The investor will use the call option and gain $10. The net profit, in this case, will be $5 ($10 – $5).
If the stock price after three months drop to $25, the call option will expire useless. The investor will use the put option and gain $5. The net profit, in this case, will be 0 ($5 – $5).
Short/Long Straddle and Strangle
When we talk about Straddle and Strangle, we generally talk about Long Straddle and Long Strangle. In the Long Straddle and Strangle, an investor is the buyer of the put and call option. On the other hand, in the Short Straddle and Strangle, an investor is the seller of the put and call option.
We can also say that investors in the long straddles and strangles benefit from sharp changes in the prices. On the other hand, in short straddle and strangle investor benefits from the sideways market movement.
Talking of payoff, long straddles and strangles carry limited risk, which equals the cost of buying the put and call option. The upside potential, however, is unlimited. When it comes to short straddle and strangle, it is the exact opposite. There is an unlimited risk (both upside and downside), and profit potential is limited to the price received for selling the options.
Since the risk is unlimited and profit potential is limited, investors go for short straddles and strangles when they expect the market to move sideways. Or, when investors expect a short position more likely to be profitable.
Straddle and strangle are very good strategies for a risk averse investor. Though they work as expected in normal market conditions, in case of big price swings they could prove very costly for the seller. This is because a seller takes an unlimited risk on both upside and downside.