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Using Straddles & Strangles to profit from market uncertainties

 

 

Straddles and Strangles are option strategies that allow investors to profit from significant moves in the underlying, irrespective of the direction. The strategies are generally used when traders notice or perceive that the options premium/s are mispriced due to a future event and may not represent the actual outcome of the underlying.
A quick understanding of the concept, risks and how they are different from the other.

Straddles-
The strategy involves buying/selling equal number of call and put options at the same strike price and the same expiry date. The strategy is typically a delta-neutral strategy to begin with since it comprises of buying/selling “At the Money (ATM) Calls and Puts.”
If you’re buying a straddle, you’re not making a directional bet, rather you expect the price of the underlying to be extremely volatile in the near-term and hope to profit from this volatility. You can also initiate long straddle trades if the option premiums are under-priced.

On the other hand, if you’re selling/writing a straddle, you still do not have a directional bias but anticipate the price of the underlying to remain within a particular range. If you are on the short side of a straddle strategy, you expect to profit from a decline in the option premium as a result of time decay. Straddles are generally sold when the option premiums are over-priced.

The following pic illustrates the payoff for a long straddle

Source: Compositedge- Protrader terminal

Risk-
Long Straddle-
Long straddles comprise of buying “At the Money” calls and puts which are generally expensive. To profit from the strategy, the implied volatility should rise significantly for the price of the underlying to rapidly move in either direction. The potential downside in a long straddle is the premium paid to buy the calls & puts.
If you are thinking of a long straddle strategy, you are typically long gamma, long Vega and negative theta.

Short Straddle-
A short straddle strategy is generally a high-risk trade since losses are unlimited and profits are maxed out to the premiums received from selling the calls and puts. Straddles are generally sold when the implied volatility is high and you expect it to calm down in the near future.
In a short straddle, you are typically short gamma, short Vega and positive theta.

 

Strangles-
The strategy involves buying/selling equal number of call and put options having the same expiry date but at different strike prices and the. The strategy typically comprises of buying/selling “Out of the Money (OTM) Calls and Puts.” Many of the characteristics of strangles are similar to those of straddles.
If you’re buying a strangle, you are again not making a directional bet, but expect the price of the underlying to be extremely volatile in the near-term and hope to profit from this volatility. Since long strangles comprise of buying OTM options, the premium paid is considerably less when compared to a straddle.

Likewise, if you’re selling/writing a strangle strategy, you still do not have a directional bias but anticipate the price of the underlying to remain within a particular range, but with a larger margin of error. If you are on the short side of a strangle strategy, you again expect to profit from a decline in the option premium due to time decay.

The following pic illustrates the payoff for a short strangle

Source: Compositedge- Protrader terminal

Risk-
Long strangle-
Since the strategy generally comprises of OTM options, the premiums paid are comparatively lower to that of a straddle, but the risks are relatively greater since the probability of losing the entire premium is higher to that of a long straddle strategy. The potential downside in a long strangle is similar to that of a long straddle; the premium paid to buy the calls & puts.

Short strangle-
A short strangle strategy is again a high-risk trade although the margin for potential losses are greater compared to straddles. Here again, strangle strategies are sold when the implied volatility is high and you expect it to quieten down in the immediate future.

 

Conclusion-
Following are some of the events where these strategies are typically used

  • Prior to the monetary policy decision of a country’s Central bank
  • Before the announcement of the general budget.
  • Preceding the publication of key economic numbers
  • Awaiting the outcome of the country’s elections
  • In anticipation of corporate earnings, board meetings, change in management etc.

 

Both straddles and strangles are excellent strategies if you are a buyer and certain that the volatility in the underlying will rise in the near future and prices will move significantly in one direction. On the contrary, if you are a seller, the strategies will yield substantial returns even if prices are volatile within a range.
The three key factors that could assist you in going for a long or short straddle/strangle are

  1. Option price
  2. Implied volatility
  3. Chart pattern

 

 

Compositedge, incorporated in 1995, is a leading discount broker and provider of algo trading solutions for retail customers in India. Headquartered in Bangalore, we provide the internationally acclaimed Protrader platform, which comprises of charts, scalper, matrix, grid, time & sales, market-depth and options master in addition to the state of the art algo trading platform. We combine discount broking and algo trading solutions to ensure all our retail clients experience the finest trading amenities at affordable costs.