Straddles & Strangles
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Essentials
Long Straddle
Long 1 XYZ Sep 50 call @ $2.00, Long 1 XYZ Sep 50 put @ $1.75
Total Cost Option Premium Paid, $375
Maximum Loss Option Premium Paid, $375
Maximum Profit Unlimited Potential
 
Short Straddle
Short 1 XYZ Sep 50 call @ $2.00, Short 1 XYZ Sep 50 put @ $1.75
Total Credit Received Net option premium received, $375
Maximum Loss Unlimited Potential
Maximum Profit Net option premium received, $375
 
Long Strangle
Long 1 XYZ Sep 40 put @ $1.00, Long 1 XYZ Sep 60 call @ $.75
Total Cost Option Premium Paid, $175
Maximum Loss Option Premium Paid, $175
Maximum Profit Unlimited Potential
 
Short Strangle
Short1 XYZ Sep 40 put @ $1.00, Short 1 XYZ Sep 60 call @ $.75
Total Credit Received Net option premium received, $175
Maximum Loss Unlimited Potential
Maximum Profit Net option premium received, $175

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Explanation and Application

The names "straddle" and "strangle" may give you clues about these option positions. Like your favorite politician trying to win both Democratic and Republican votes, these positions are on both sides of the issue. Long straddles and strangles make money if the stock price moves up or down significantly. Who cares which way the stock goes, so long as it GOES!

Straddles and strangles are essentially speculations on whether the price of the stock will move a lot or not or implied volatility is going to go up or down. If you think the stock is going to move big in one direction or another and/or if you think implied volatility is going to rise, you would buy a straddle or strangle. If you think the stock is going to sit still or not move very much and/or if you think implied volatility is going to fall, you would sell short a straddle or strangle.

A long straddle is long 1 call and long 1 put at the same strike price and expiration and on the same stock. A long strangle is long 1 call at a higher strike and long 1 put at a lower strike in the same expiration and on the same stock. Such a position makes money if the stock price moves up or down well past the strike prices of the strangle. Long straddles and strangles have limited risk but unlimited profit potential.

The simplest reason to buy straddles and strangles is that they manufacture long deltas if the underlying stock rallies, and short deltas if the underlying stock falls. Long deltas on the way up and short deltas on the way down? What's the catch? Straddles and strangles can be expensive to buy, and if the stock price just sits there, or moves very little, losses can be large.

A short straddle is short 1 call and short 1 put at the same strike price and expiration and on the same stock. A short strangle is short 1 call at a higher strike and short 1 put at a lower strike in the same expiration and on the same stock. Such a position makes money if the stock price stays at the strike of the straddle or in between the strike prices of the strangle. Short straddles and strangles have unlimited risk and limited profit potential.

Selling straddles and strangles can be attractive, but always dangerous. Just as a long straddle can lose money at an alarming rate when the stock price doesn't move at all, a short straddle makes all the money in that scenario. But the profits collected quickly disappear if the stock price moves too much. Potential losses on short straddles and strangles are unlimited. Being short straddles and strangles is too dangerous for all but the most experienced and well-capitalized trader who can employ defensive tactics quickly if things go wrong.

Long butterflies and condors are two ways to get some of the advantages of short straddles and strangles without the unlimited risk.


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Greeks

If you can understand the greeks for calls and puts, you can understand the greeks for straddles and strangles.

The delta of straddles and strangles can range from positive to negative to neutral, depending on where the stock price is relative to the strike price(s). Remember that the sum of the absolute value of the deltas of the call and put at the same strike price and expiration equals 1.00. What that means in the case of a straddle is that when the call delta increases, the put delta must decrease. So, for an XYZ Dec 100 straddle with the stock price at $100, the delta of the straddle is very close to 0, because the long call has a delta of around .50 and the long put has a delta around -.50. But if the stock price starts to fall, the delta of the long put might go to -.70, making the delta of the long call around .30. The delta of the straddle would be, then, -.40. If the stock price then began to rise back to $100, the delta of the straddle would move from -.40 back to around 0.

The delta of a strangle is governed by which strike price the stock price is closest to. When the stock price is at the exact midpoint between the two strikes of the strangle, the delta of the strangle is typically close to zero, but different implied volatilities at the two strikes (volatility skew) can change that. But if the stock price rises to the higher strike, the call delta grows more positive, and the put delta becomes less negative. The delta of the long strangle therefore becomes positive. If the stock price falls closer to the lower strike, the put delta grows more negative, and the call delta becomes less positive. Therefore, the delta of the long strangle becomes negative.

The gamma of a long straddle or strangle is always positive; the gamma of a short straddle or strangle is always negative. But like delta, the gamma of the straddle depends on where the stock price is relative to the strike price. The gamma of a straddle is highest when the stock price is at the strike price. This makes sense, because gamma for an option is highest when the stock price is equal to the strike price. The long gamma indicates the long straddle wants the stock price to move. The higher the positive gamma, the more positive delta will be manufactured as the stock price rises, the more negative delta as the stock price falls. As the stock price moves away from the strike price of the straddle, gamma starts to decrease. When the stock price moves, the options become either ITM or OTM, and their gamma drops accordingly.

Just as gamma increases as implied volatility falls or as time passes, the gamma of a straddle grows the closer it is to expiration or if implied volatility falls. That means that the delta of a straddle with many days before expiration will not change as much as that of a straddle with fewer days to expiration when the price of the stock moves up or down. This translates into the price of the straddle with more days to expiration not changing as much as the price of the straddle with fewer days to expiration when the stock price moves. Why, then, wouldn't you buy straddles near expiration? Read on.

Although it is true that a long gamma position creates deltas in a direction consistent with the market direction (how wonderful!), remember that there is a luxury tax attached to this position (ouch!). The problem is negative theta, which means that your asset is wasting away. Theta, or time decay, is highest for straddles near expiration. So, a long straddle can lose quite a bit of money as it gets close to expiration. When a straddle's gamma is highest, so is its time decay. That's the gamma/theta tradeoff. The gamma gives you lots of power to exploit a change in the price of the stock, but theta is making you pay for that power.

Gamma and theta are smaller for strangles than they are for straddles. Even if the stock price is exactly at one of the strike prices, remember that you only have one option (either a call or a put) at that strike with the strangle versus two options (a call and a put) with the straddle. So, all other things (implied volatility, time to expiration, interest rates) being equal the straddle has higher gamma and theta than a strangle.

Long straddles and strangles always have positive vega, and short straddles and strangles always have negative vega. That's why they are popular strategies to exploit changes in implied volatility. If you think volatility is going up, but unsure of the direction of the stock price, buying a straddle or strangle is a good strategy with limited risk. The amount of vega that a straddle or strangle has depends on, like the other greeks, where the stock price is relative to the strike of the options. Vega is highest for a straddle when the stock price is exactly at the strike price. It is highest for a strangle when the stock price is at one of the strikes.

Vega is higher for straddles and strangles that have more days until expiration. So, if your speculation is that implied volatility will rise, a long straddle with more days until expiration might be the best strategy. Remember, though, that the price of a straddle with more days until expiration will not change as much as one with fewer days until expiration when the stock price moves up or down. That's another tradeoff a straddle that works best for changes in implied volatility doesn't necessarily work best for changes in the stock price.

Please allow us a short digression. Have you ever come across an options trader who proudly announced that he bought volatility at 25 percent and sold it at 30 percent, implying that it was a profitable trade? It simply is not enough information to react to. You cannot determine whether the trader made any money when he says that alone. What if the purchase had been 25% with 30 days to go and the sale at 30% had been with 3 days to go, while the stock price was virtually unchanged throughout the period? That would probably be a losing trade. If, on the other hand, the trader is talking about a two-year LEAP option that was liquidated one day after it was purchased with the stock price unchanged, that would probably be profitable. Unfortunately, many people talk about implied volatility as if it were money. Volatility is not money! This is a failure to realize that implied volatility is only one part of an option's value.

Balancing theta, gamma, and vega and/or isolating your speculation to changes in implied volatility or stock price is something you'll have to think about before trading straddles and strangles. Use the thinkorswim analyzer on the trading application and stress--test your ideas before you do the trade.

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Straddle and Strangle Structure

Straddles and strangles are relatively straightforward positions, you buy a call and a put, or you sell a call and a put. Generally, though, they are established to be delta-neutral (i.e. the delta of the straddle is close 0). So, if you bought one XYZ Apr 100 call and one XYZ Apr 100 put, with the price of XYZ at $100, you would have a long straddle with a delta very close to 0. But what if you bought one XYZ Apr 80 call (with a delta of +.75) and one XYZ Apr 80 put (with a delta of -.25)? That straddle would have a positive delta of +.50 (+.75 - .25). So, in order for the straddle to be delta-neutral, you would have to buy more of those XYZ Apr 80 puts. In fact, you would have to buy 3 of the XYZ 80 puts to create a delta-neutral straddle (+.75 - 3*.25). Any time you buy or sell a straddle with more of one option than another, it's called a "ratioed straddle".

Where this is most applicable is when you are long stock, and you buy puts or sell calls as a hedge. For example, if you are long 100 shares of XYZ stock, and you want to buy puts as a hedge, you could buy 4 of the XYZ Apr 80 puts (each with a delta of -.25). The resulting delta of the position would be close to 0 (1.00 - (4*.25)). Your position would basically be long a ratioed straddle, and it would act the same as if you were long 1 XYZ Apr 80 call and long 3 XYZ Apr 80 puts. The long 100 shares of XYZ and long 1 of the XYZ Apr 80 puts is synthetically long 1 XYZ Apr 80 call, which leaves long 3 actual XYZ Apr 80 puts.

If you are long 100 shares of XYZ stock, and you sell calls as a hedge, you could sell 3 of the XYZ Apr 110 calls (each with a delta of .33). The resulting delta of the position would be close to 0 (1.00 - (3*.33)). Your position would basically be short a ratioed straddle, with unlimited risk and limited potential for profit. The long 100 shares of XYZ and short 1 of the XYZ Apr 110 calls is synthetically short 1 XYZ Apr 110 put, which leaves short 2 actual XYZ Apr 110 calls.

This does not imply that any position that is delta-neutral acts like a straddle - far from it. But do realize that there are different ways of establishing a straddle or ratioed straddle.

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Pricing

The price of a straddle or strangle varies according to implied volatility and where the stock price is relative to the strike price. All other things being equal, a straddle whose strike price is equal to the price of the stock is cheaper than a straddle whose strike price is not equal to the price of the stock. The reason is that the straddle whose strike is equal to the price of the stock is made up of a call and put whose value is all extrinsic, while the straddle whose strike price is not equal to the price of the stock is made up of an ITM call (put) and an OTM put (call). Even though extrinsic value is highest for the ATM options, the decrease in extrinsic value for ITM and OTM options is offset by the intrinsic value of the ITM option. This is why straddles make money when the stock price moves up or down -- the accumulation of intrinsic value in the call or put.

A straddle is theoretically worth zero if the stock price is equal to the strike price at expiration. The reason the straddle is theoretically worth zero in this case is that the call and the put have zero intrinsic value and zero extrinsic value. In reality, even at the strike price, a straddle in a stock, will expire with a little value in it because there is still the chance that some one will want to exercise either the call or put after the market closes on Friday but before the options expire on Saturday. At expiration, the value of a straddle depends on the intrinsic value of either the call or the put. If either call or put has sufficient intrinsic value to offset the original price of the straddle the position is profitable, otherwise it loses money.

The same principal applies to strangles. If the price of the stock is in between the two strike prices of the strangle at expiration, the strangle is worthless. For a long strangle to be profitable at expiration, the stock price has to be sufficiently higher or lower than the strike prices to give either the call or put enough intrinsic value to offset the original cost of the strangle.

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