Understanding the straddle and strangle strategies

The straddle and strangle are options trading strategies used in Singapore to generate income or reduce risk.

These two strategies are executed using puts and calls, respectively, where the trader holds both a put and call with the same strike price and expiration date (hence why it is called ‘straddling’).

The difference between the two lies in what comes before this; there are different factors to consider when choosing which one to use.

The propriety of either option strategy depends on certain key factors, such as volatility, the direction of trade, time until expiry, etc.

This article aims to shed some light on exploring these strategies further through their underlying concepts.

Understanding the basics

First off, let us look at an example of each strategy.

A first example is a straddle option, where an investor will hold both a put and call with the same strike price (K) and expiration date (T).

It means that one does not already know which direction they would like to take; instead, they are taking on more risk by holding options with the same strike price.

For this reason, it is best used when volatility in the market is expected to increase significantly.

As seen below, given an initial investment of $4 for buying one contract (P0), our trader has gained $1.60 at expiry by selling one strangle (L1), then gaining another $3.40 from the long call position (L2)by expiry.

Using a Straddle

Strangle Example:

In the second example, our trader has executed a strategy known as strangle, a long put/short call position, i.e., buying a put and selling a call with the same strike price (K).

This options strategy is more suitable for when the market direction is unknown, taking on less risk. It can generate income if there is an expectation of limited movement in the underlying by expiry.

As seen below, our initial investment of $4 gives us -$2 from one short call position (S0) and -$0.40 from another more concise call position (D1), then gains us $1 from one long put position (P1) and $3 from the other long put position (P2) by expiry.

Using a Strangle

Strike price As seen in both examples, the option strategies hold positions with the same strike price. It indicates that one is expecting some level of volatility to play out in the market before expiry in both cases.

Put, one expects more significant fluctuations of price movements over a short period.

The higher the expected volatility, the more likely for either straddle or strangle due to an increased chance for substantial activity within the trade horizon.

Volatility

Volatility refers to how much prices fluctuate over time, where it can be high or low depending on certain conditions of supply and demand for that security.

When there is high volatility, the stocks are expected to move by more excellent percentage points in a shorter period.

Thus, it is easier to predict large fluctuations on either option strategy before expiry.

From the examples above, you can see how our trader had executed the straddle when the volatility of price movements was anticipated to be higher using this options trading strategy in Singapore.

Time decay

An option’s premium decays over time due to its’ being ‘time-sensitive’. It refers to how its value decreases with every passing day as expiration nears closer till it becomes worthless at the end of its life span.

The chart below shows an example of how time decay affects our long call position (L2)through time, where the ‘+’ sign represents how it increases in value, and the ‘-‘ character decreases.

An option’s premium decays over time due to its time sensitivity, where a long call position (L2) will increase and decrease in value.

From the example above, we can see how time decay has no effect at all on our trader’s short call position (S0) nor put position (P0).

It is advantageous for him as he shorts both options as they decay slowly but surely as expiry approaches.

This strategy is called ‘credit spreading’, where one makes money from selling their options without owning them, also known as S sold OTM.

To own an option, one must buy it. However, costs can be reduced by purchasing a chance with a more incredible call/put than the one that’s already shorted, i.e., one long + 2 shorts.

This would be known as ‘debit spreading’, where one makes money from buying options.

Key takeaways

  • Buying straddles or strangles are profitable when volatility is expected to increase.
  • Both strategies hold positions with the same strike price because of expectations of market fluctuation.
  • The higher the expected volatility, the more likely it is for either approach to be profitable due to an increased chance for substantial movement within the trade horizon.
  • Risk-taking comes at a cost as profit potentials are limited if there is no movement in prices.

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