Straddles and strangles are option strategies that allow an investor to profit from significant price moves either upward or downward in the underlying stock.
These strategies combine call and put options to create positions where an investor can profit from price swings in the underlying stock, even when the investor does not know which way the price will swing. This article will explain the similarities and differences of these two strategies and show how an investor can profit from each.
In the straddle strategy, an investor holds a position in a call and put option with the same strike prices and expiration dates for the same underlying stock. In the strangle strategy, an investor holds a call and put option with the same expiration dates but different strike prices for the same underlying stock.
In a straddle position, an investor holds a call and put option that is “at-the-money.” In a strangle position, an investor holds a call and put option that is “out-of-the-money.” Because of this, getting into a strangle position is generally cheaper than getting into a straddle position.
Let’s look at an example of each strategy to gain a better understanding of how these strategies work.
Straddle Example
Assume the stock for PayPal Holdings (NYSE: PYPL) is trading at $80. An investor executes a straddle strategy by buying a call option and a put option for PYPL. Both options have a strike price of $80 and expire in a month. Assume the cost of each option was $3 per share. Therefore, the potential maximum loss and the net debit entering the trade is $6 per share.
If PYPL is trading at $90 at expiration, then the call option could be exercised and the put option would expire worthless. By exercising the call option, the investor can buy shares of PYPL at the strike price of $80, then immediately sell the shares at the market price of $90. From this, the investor will earn a profit of $10 per share. However, after accounting for the premiums that the investor paid, the total profit becomes $4 per share.
If PYPL is trading at $70 at expiration, then the put option could be exercised and the call option would expire worthless. By exercising the put option, the investor can buy shares of PYPL at the market price of $70, then sell the shares at the strike price of $80. From this, the investor will earn a profit of $10 per share. Again, after accounting for the premiums that the investor paid, the total profit becomes $4 per share.
If PYPL is trading at $80 at expiration, then the call option and put option would both expire worthless. The investor will suffer a maximum loss of $6 per share, which comes from the two premiums that were paid for the options.
Strangle Example
Assume the stock for Nike (NYSE: NIK) is trading at $75. An investor executes a strangle strategy by buying a call option and a put option for NIK. Both options expire in a month. The call option has a strike price of $80. The put option has a strike price of $70.
Assume the cost of each option was $1 per share. Therefore, the potential maximum loss and the net debit entering the trade is $2 per share.
If NIK is trading at $80 at expiration, then the call option could be exercised and the put option would expire worthless. By exercising the call option, the investor can buy shares of NIK at the strike price of $75, then immediately sell the shares at the market price of $80. From this, the investor will earn a profit of $5 per share. After accounting for the premiums that the investor paid, the total profit becomes $3 per share.
If NIK is trading at $70 at expiration, then the put option could be exercised and the call option would expire worthless. By exercising the put option, the investor can buy shares of NIK at the market price of $70, then sell the shares at the strike price of $75. From this, the investor will earn a profit of $5 per share. After accounting for the premiums that the investor paid, the total profit becomes $3 per share.
If NIK is trading anywhere between $70-$80 at expiration, then the call option and put option would both expire worthless. The investor will suffer a maximum loss of $2 per share that comes from the two premiums paid for the options.
Closing
After looking at these two examples, investors should understand how the straddle and strangle option strategies work. These strategies are effective tools that can be used when an investor wants to profit from a volatile stock.
