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FM - Straddle and Strangle

The straddle and strangle strategies allow investors to profit from significant moves in the price of a stock or currency exchange rate in either direction. A straddle involves buying a call and put option with the same strike price, while a strangle uses different strike prices. Investors use these strategies when they expect high volatility but are uncertain about the direction of movement. For example, an investor may enter a straddle position before an upcoming announcement that could sharply impact a stock's price in either direction. Sellers of these options strategies profit when prices remain stable near the strike price.

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239 views

FM - Straddle and Strangle

The straddle and strangle strategies allow investors to profit from significant moves in the price of a stock or currency exchange rate in either direction. A straddle involves buying a call and put option with the same strike price, while a strangle uses different strike prices. Investors use these strategies when they expect high volatility but are uncertain about the direction of movement. For example, an investor may enter a straddle position before an upcoming announcement that could sharply impact a stock's price in either direction. Sellers of these options strategies profit when prices remain stable near the strike price.

Uploaded by

priyam_22
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Straddles 

and strangles are both options strategies that allow the investor to gain on significant moves
either up or down in a stock’s price. Both strategies consist of buying an equal number of call and put
options with the same expiration date; the only difference is that the strangle has two different strike
prices, while the straddle has one common strike price.

For example, let’s say you believe your favorite diamond mining company is going to release its latest
results in three weeks time, but you have no idea whether the news will be good or bad. This would be a
good time to enter into a straddle, because when the results are released the stock is likely to be more
sharply higher or lower.

Let’s assume the price is currently at $15 and we are currently in April 05. Suppose the price of the $15
call option for June 05 has a price of $2. The price of the $15 put option for June 05 has a price of $1. A
straddle is achieved by buying both the call and the put for a total of $300: ($2 + $1) x 100 = 300. The
investor in this situation will gain if the stock moves higher (because of the long call option) or if the
stock goes lower (because of the long put option). Profits will be realized as long as the price of the stock
moves by more than $3 per share in either direction. A strangle is used when the investor believes the
stock has a better chance of moving in a certain direction, but would still like to be protected in the case
of a negative move.

For example, let's say you believe the mining results will be positive, meaning you require less downside
protection. Instead of buying the put option with the strike price of $15, maybe you should look at
buying the $12.50 strike that has a price of $0.25. In this case, buying this put option will lower the cost
of the strategy and will also require less of an upward move for you to break even. Using the put option
in this strangle will still protect the extreme downside, while putting you, the investor, in a better
position to gain from a positive announcement.

The straddle strategy:


Investors use this option trading strategy when they expect a sharp swing in the exchange rate
but don’t know if it’s going to go up or down. This happens during highly volatile market
conditions. In this case, they use a buying straddle strategy. On the other side of the transaction,
sellers use this forex option strategy in a stable market, when they expect neither sharp rise nor
sharp fall in the exchange rate. In this case, they use a selling straddle strategy.

This is one of the most popular forex options trading strategies and it consists in buying (in the
case of a volatile market) or selling (in the case of a stable market) both a call and a put option
at the same strike price and for the same maturation date. The value of a straddle option (the
premium or price of the option paid at spot value) increases along with the volatility and the
maturity of the underlying currency pair.
Long straddle strategy

Short straddle strategy

Possible outcomes of a straddle strategy:


For the buyer (long straddle)

If, after buying a call and a put option at a same strike price, the market remains stable and the
volatility remains at low levels, the buyer loses the two premiums he paid for each option.

If the market rises far above the strike price, above the rate where the buyer starts making profit
(the break-even rate), the buyer will exercise his right to the call option he purchased and buy the
underlying currency at the strike rate. The sharper the rise, the greater the chance of making
profit. If there is a sharp rise in the exchange rate, the buyer will make some profit as long as this
profit is higher than the two premiums he paid in advance.

If the market falls well below the strike price, below the break-even rate (the point where his
profit is greater than the two premiums he paid in advance), the buyer will exercise his right to
the put option and sell the currency at the strike price. The sharper the decline of the currency,
the greater the chance of making profit.

If the buyer purchased his options at a time of low volatility and volatility rises, he could profit
from both options even with small market moves.

For the seller (short straddle)

If there is little or no change in the spot rate, the options contracts will expire worthless and the
seller will keep both premiums (this represents the maximum profit). The seller will still profit if
the exchange rate remains below the strike price – as long as it is above the lower break-even
rate. The seller will also profit if the spot rate remains above the strike price – as long as it is
below the upper break-even rate. In any case, the writer of the straddle will benefit if the spot
rate remains very close to the strike rate.

The seller will incur losses if the there is a sudden swing in either direction. There is no limit to
the losses he/she might incur.

The strangle strategy:


This is also one of the most popular options trading strategies. It consists in buying or selling a
call and a put option at different strike prices. Like the straddle buying strategy, traders use the
strangle buying strategy when they expect a sharp swing of the exchange rate in either direction.
The buyer will purchase an out-of-the-money call option contract as well as an out-of-the-money
put option contract. The strangle buying strategy has unlimited profit potential if the exchange
rate moves enough in either direction. The value of a strangle option increases along with the
volatility of the underlying currency.

Long strangle strategy


Short strangle strategy

On the buyer’s side:


Using this strategy, a trader (buyer) can benefit from a sudden movement of the exchange rate
regardless of the direction. The potential profit is unlimited and the potential loss is limited to the
two premiums. If the exchange rate expires between the two strike prices, the buyer will sustain a
maximum loss (the value of both options). For the buyer to make a clean profit, the spot rate at
the expiration date will have to either be above the upper break-even rate or below the lower
break even.

On the seller’s side:


If the exchange rate remains between both strike prices at expiration, both the put and the call
options will expire worthless and the seller will keep the value of both premiums (maximum
profit). The seller will make some profit even if the spot rate is below the put strike, as long as it
is above the lower break even rate. The same way, he/she will still profit to some extent if the
spot rate is above the call strike price, as long as it is below the upper break-even point. Also,
since the seller uses two different strike prices, the spot rate enjoys a wider moving range than in
the short straddle strategy to be profitable.

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