By Stephen Karpin, CommSec 

Question:

What are straddles and strangles?

Response:

The straddle and strangle are popular option strategies that involve a simultaneous buying or selling of an equal number of call and put options with the same expiration date. The only difference between the strategies is that the strangle has two different strike prices, while the straddle has the one common strike price.

The long straddle is the simultaneous purchase of an at-the-money call and an at-the-money put option.  Both options have the same underlying stock and expiry month.  A long straddle is a possible strategy to use when you think there is a large move coming in the underlying price but unsure about the direction.

A long strangle is similar to a straddle except the strike prices are further apart, i.e. out of the money strikes, which lowers the cost of executing the spread but also widens the gap needed for the underlying price to rise/fall beyond in order to be profitable. Like a long straddle, a long strangle is best traded when the implied volatility is low and or you expect a large movement of the underlying price in either direction.

An upcoming earning season is a good example. All else being equal, if the earnings report is encouraging; the underlying security is likely to rise along with the call option while the put option premium will erode. However if the earnings report is disappointing, the underlying security is likely to fall therefore the put option premium will rise and the call option premium will erode.

The risk with a long straddle and strangle is if the large movement in the underlying price and rise in volatility do not eventuate. In this situation, it is best to close the long straddle/strangle to recoup the option premium as it is negatively impacted by time decay and decreases in volatility. All premium are paid at time of opening the trade and you cannot lose more than what you pay upfront initially (maximum loss).

A short straddle/strangle is the opposite of a long straddle/strangle i.e we are selling the call and put option rather than buying the options.   Effectively, your trading view is the opposite of a long straddle/strangle, that is you do not anticipate a large move either up or down in the underlying price throughout the period and you expect a possible decrease in volatility.

Both short straddle and short strangle have limited profit potential but unlimited risk.  Substantial losses are possible with a big move in the underlying price over the periods or a major increase in volatility. There is also an initial and variation margin involved in these spreads to cover the risk.

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The views expressed in this article are those of Brian Phelps, a representative of Commonwealth Securities Limited (CommSec) ABN 60 067 254 399 AFSL 238814.  Commonwealth Securities Limited (CommSec) is a wholly owned but non-guaranteed subsidiary of the Commonwealth Bank of Australia ABN 48 123 123 124 and a Participant of the ASX Group and the Sydney Futures Exchange. As this information has been prepared without considering your objectives, financial situation or needs, you should, before acting on this information, consider its appropriateness to your circumstances and if necessary, seek appropriate professional advice.

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