In chapter 5 we saw that if you were bullish meaning that you thought the market was going higher , you could purchase a call in an attempt to make money. And if you were bearish meaning that you thought the market was going lower , you could purchase a put option to profit.
But what if you thought the market was going to move in a big way — but you had no idea which direction. If the market moves up dramatically, then the call will profit while the put expires worthless. Should the market do the reverse, the put will profit and the call will expire worthless. The key is that the markets have to move enough to pay for both the call and the put option since one will expire worthless.
We can use the same option chain from before to learn more about straddles and strangles. We can learn both strategies simultaneously since they are almost the exact same thing. Suppose you were walking along a picket fence and slipped while you had one leg landing on each side of the fence. And if you could distract yourself from the pain for a moment, you might realize that this is the exact same thing as an option straddle.
Guys know what this would mean. Now think in terms of an option straddle. If the market moves just a tad to the left down in price , the put option will pick up intrinsic value.
If the market moves just a tad to the right up in price , the call option will be In the money In other words, there is only one place that the straddle will not have intrinsic value, and that is right at the strike price.
A long straddle is the purchase of both a call and put option which share a common expiry month and strike price — usually done at-the-money. Prior to expiration, the straddle can start making money once the stock moves, but will be fighting against the time decay that takes place every day. If the stock does not move enough to compensate for the time decay, a loss will start and get larger every day. If the stock does not move, a profit is neither made nor lost, but once the stock moves you will begin to make a profit.
And though it may be tempting to place this trade based on looking at this T1 line, you have to keep in mind that you will be fighting time decay immediately after you place the trade. This is what the profit and loss will look like shortly after the trade has been placed — call it one week later. You will notice that, unlike when the trade was initially placed and the stock did not have to move much to make a profit, the time decay has eaten into the original value of the straddle.
The stock has to move a good deal for the trade to even get back to its original purchase price. This line can represent more time elapsing. In this case, we can pretend it is yet another week. Notice that the amount the stock has to move in either direction to break even or make money is even larger now that more time passed. Entering a straddle is just like entering a naked call or put option trade. There are two differences:.
These are strategies used by people when they feel that the market is going to move one way or the other in a big way. Here is a short list of some of the items that can precipitate a large move:. For example, earnings in Apple computer will come out in a few days. If earnings are good, the stock will run higher. If bad, it will fall harder. The Dow or large stock is at a major number. For example, the Dow is nearing all-time highs of 14, Many times the market will retrace after people sell and take profits.
Yet, if the stock market goes through this number, it can move fast because the sellers do not exist as anticipated. For example, Greece is going to default on loans and it could send shock-waves throughout the European region. If Greece defaults, the whole European community could take a big financial loss as they lend to Greece. For those expecting a large move, it is hard to beat a straddle or strangle, especially if the move is down and volatility is increasing.
Remember from the section on the greeks that you are long [own volatility] when you own an option. An increase in volatility is beneficial to your position. Many people understand the straddle better when they see how the position reacts through a given set of stock prices. Just as for every buyer of a call or put option there is a corresponding seller, the same applies for a straddle. Looking at a 3 month chart of the stock in Figure 6.
Looking at Figure 6. Although selling an option did not seem logical at first, there is never a shortage of people willing to take either side of any trade provided the price is realistic. You can think of a trading strangle in terms of an actual strangle.
When you are strangling someone, you will place one hand on one side of his neck, and one hand on the other side of his neck. No matter how hard you squeeze, your palms will never meet. The same holds true with an option strangle. You will place an option on one side of the stock and another option on the other side of the stock. We just went over the basics of a straddle and how they react to stock movement and time decay.
The strangle will be very easy to understand since it is almost the same strategy as the straddle. Strangle Definition A long strangle is the purchase of both a call and a put option which share a common expiry month — BUT a different strike price. Both options are usually out-of-the-money. The only difference between a straddle and a strangle is the selection of the strike prices.
The straddle will always share a common strike price, while the strangle has two different strike prices. Yet this is usually not a possibility. In that case, we would have missed out on making money on the straddle.
Think of it as leapfrogging the ITM call to the next strike higher. The image below is of the strike straddle where the strike call gets moved out to the strike. This is the most common form of strangles — where both the call and the put are out-of-the-money but they are as close to the stock price as possible.
And though this is the most common form of a strangle, having the strike prices as close to the stock as possible is not a requirement. One could place the strangle many, many strikes apart from the stock and it would still be a strangle. Look at the graph of a strangle to find the break-even points and see just how much the stock has to move to make a profit on the trade. You will notice that, when we were looking at the straddle, there was only one sharp point the strike price where you could lose your entire investment when buying this strategy.
With the strangle, there is a much wider range where you can lose everything — specifically the entire distance between the two different strike prices. So why choose a straddle over a strangle? This is really a personal preference, especially when buying the spreads. When selling the spread, it often does make sense to choose one spread over the other.
Since you are an avid student of the markets and not prone to allowing laziness and chance to decide your future, you have studied the stock movement every time this name has earnings. Most of the move occurred in a 2 or 3 day period, but the selling took a full 3 weeks to finish.
Since we will be looking at a 1 month option chain for this example , this is all we need to know. Thus, the profit and loss of this strangle does not look any better than the straddle. We can either sell the strikes where we think the stock will hit a road block, or we can add a little more cushion and sell a strike that is a little further out-of-the-money.
The call, however, is a slightly different situation. To be safe given what can happen, we will sell call instead of the call since it will not be in-the-money. This is why many people will move from a straddle position to a strangle position — especially when selling options.
Look at Figure 6. The strangle has a distinct advantage when you are selling the options, but a disadvantage when you are buying them. When first learning straddles and strangles people can easily see how the positions are designed to make money on large movement in the stock in either direction. After you have become more familiar with options, you soon realize that there is a second and often even more powerful force affecting the price of these positions — volatility.
The more fear in the markets usually from fast selling off of the stock , the higher volatility gets. Conversely, when everything seems calm, volatility levels tend to be low. These different levels in volatility will greatly affect the price of a straddle, even when all other variables stock price, time until expiration, interest rates, etc. The option prices we have been using were in effect when the stock was trading on a At this point you may have either fallen in love with this strategy or decided it is not for you.
Please do not rush to judgment quite yet. At the beginning of your reading on options, you learned how market direction delta is the hardest thing to predict in the stock market. This is just a fancy term for the process of volatility swinging around an average level. When volatility is dramatically higher than this average or mean , it has a strong propensity to decline back towards the mean.
Also, when volatility is way undervalued compared to this average, it has a good statistical chance of increasing once again. Since this phenomenon is much easier to predict than market direction, many of the largest and most successful proprietary firms in the world use buying and selling of option positions such as straddles and strangles to grind out income.
Yet holding on to a long straddle or strangle position waiting for the level of volatility to increase can be expensive. Each day a long position is held results in a cost in time decay. There is good news, however! Trader s have developed a method of trading and scooping up small profits daily as the stock makes its normal swings up and down.
If you felt that the stock market was going to move up a fair amount, but nothing really significant, would buying a straddle or strangle make sense? Strangle B is the correct answer.More...