Options are contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price (strike) on or before a certain date (expiration). Options can be used for various purposes, such as hedging, speculation, income generation, or portfolio diversification.
One way to generate income from options is to sell them when they are overpriced or have high implied volatility. Implied volatility is a measure of how much the market expects the underlying asset to move in the future. The higher the implied volatility, the more expensive the options are.
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However, selling options also expose the seller to unlimited risk if the underlying asset moves significantly against their position. For example, if you sell a call option and the underlying asset rises above the strike price, you will have to buy it back at a higher price or deliver it at a lower price. Similarly, if you sell a put option and the underlying asset falls below the strike price, you will have to buy it back at a higher price or accept it at a lower price.
To reduce this risk, options sellers can use strategies that involve buying another option of the same type (call or put) but with a different strike price. These strategies are called straddles and strangles.
What are Straddles and Strangles?
A straddle is an options strategy that involves selling a call and a put with the same strike price and expiration date. A strangle is an options strategy that involves selling an out-of-the-money (OTM) call and put with different strike prices but with the same expiration date.
Both strategies are neutral on direction, meaning they do not care whether the underlying asset goes up or down. They only care about how much it moves. The idea is to collect premiums from both options and hope that they expire worthless or can be bought back for less than what they were sold for.
The difference between straddles and strangles is that straddles have higher premiums but also higher breakevens than strangles. Breakevens are points where neither profit nor loss occurs. For example, if you sell a Rs. 100 call and a Rs. 100 put for Rs. 10 each (Rs. 20 total), your breakeven points are Rs. 80 (Rs. 100 – Rs. 20) and Rs. 120 (Rs. 100 + Rs. 20). If you sell an OTM Rs. 90 call and an OTM Rs. 110 put for Rs. 5 each (Rs. 10 total), your breakeven points are Rs. 80 (Rs. 90 – Rs. 10) and Rs. 120 (Rs. 110 + Rs. 10).
As you can see, both strategies have identical breakevens but different premiums. This means that straddles require more movement in either direction to be profitable than strangles do. However, straddles also have more potential profit if there is extreme movement in either direction.
When to use Straddle Strategy? Difference between a Long Straddle and Short Straddle
A straddle strategy is an options strategy that involves buying or selling both a call and a put option on the same underlying asset with the same strike price and expiration date. A straddle strategy is used when a trader expects a large price movement in either direction but is uncertain about which direction it will be. There are two types of straddle strategies: long straddle and short straddle.
A long straddle involves buying both a call and a put option with the same strike price and expiration date. This strategy profits when the underlying asset’s price moves significantly away from the strike price, regardless of whether it is up or down. The maximum loss for a long straddle is limited to the total premium paid for both options, while the profit potential is unlimited.
A short straddle involves selling both a call and a put option with the same strike price and expiration date. This strategy profits when the underlying asset’s price stays close to the strike price, implying low volatility. The maximum profit for a short straddle is limited to the total premium received for both options, while the loss potential is unlimited.
When to use Strangle Strategy? Difference between a Long Strangle and Short Strangle
A strangle option is a trading strategy that involves buying or selling both a call and a put option of the same underlying security with the same expiration date but different strike prices. A strangle option can be used when an investor expects a price movement in either direction but within a broadly defined range but is unsure about which way it will go. There are two types of strangle options: long and short. A long strangle involves buying an out-of-the-money call and an out-of-the-money put, which means that both options have strike prices that are away from the current market price of the underlying security.
A long strangle profits when the price of the underlying security moves beyond either strike price by more than the total premium paid for both options. A short strangle involves selling an out-of-the-money call and an out-of-the-money put, which means that both options have strike prices that are close to the current market price of the underlying security.
A short strangle profits when the price of the underlying security stays within a range between both strike prices by less than the total premium received for both options. A strangle option is different from a straddle option, which involves buying or selling both a call and a put option of the same underlying security with the same expiration date and **the same** strike price.
Options are risky because they involve leverage, time decay, and volatility of the underlying asset. One should always use professional help when trading options because they require a thorough understanding of the factors that affect their value and risk.
Milan Vaishnav, CMT, MSTA
Consulting Technical Analyst
Member: (CMT Association, USA | CSTA, Canada | STA, UK) | (Research Analyst, SEBI Reg. No. INH000003341)
