Option Strategies: Straddle, Strangle, Spreads

Straddle

A straddle is an options strategy in which the investor holds a position in both a call and put with the same strike price and expiration date, paying both premiums. This strategy allows the investor to make a profit regardless of whether the price of the security goes up or down, assuming the change in the underlying stock price is significant enough to move past either of the strike prices and offset the cost of the premiums.

Straddles are a good strategy to pursue if an investor believes that a stock’s price will move significantly but is unsure as to which direction. This is a neutral strategy. The investor is indifferent whether the stock goes up or down, as long as the price moves enough for the strategy to earn a profit.

Straddle Mechanics and Characteristics

The key to creating a long straddle position is to purchase one call option and one put option. Both options must have the same strike price and expiration date. If non-matching strike prices are purchased, the position is then considered to be a strangle, not a straddle.

Long straddle positions have unlimited profit and limited risk. If the price of the underlying asset continues to increase, the potential profit is unlimited. If the price of the underlying asset goes to zero, the profit would be the put’s strike price less the premiums paid for the options. In either case, the maximum risk is the total cost to enter the position, which is the combined cost of the call and put option.

The profit when the price of the underlying asset is increasing is:

Profit(up) = Price of the underlying asset – the strike price of the call option – net premium paid. Since each stock option represents 100 shares, the profit is multiplied by 100 for one contract, 200 for two contracts, and so on.

The profit when the price of the underlying asset is decreasing is:

Profit(down) = Strike price of put option – price of the underlying asset – net premium paid. As with the scenario above, multiply by 100 (one contract) to get the total profit on the trade.

The maximum loss is the total net premium paid plus any trade commissions.

There are two breakeven points in a straddle position. The first, known as the upper breakeven point, is equal to strike price of the call option plus the total premium cost. The second, the lower breakeven point, is equal to the strike price of the put option less the total premiums paid.

Straddle Example

A stock is priced at $50 per share. A call option with a strike price of $50 is priced at $3, and a put option with the same strike price is also priced at $3. An investor enters into a straddle by purchasing one of each option.

The position will profit at expiration if the stock is priced above $56 or below $44. If the stock moves to $65, the position would profit:

Profit = $65 – $50 – $6 = $9

If the trader bought and sold one contract they make $9 x 100 shares = $900. They laid out $600 for the trade [($3 x 100) + ($3 x 100)].

If the stock price is right at $50 at expiration, they lose $600. If the price is above or below $50, they will recoup some of their cost since one of the options will have some intrinsic value. They can sell the option with intrinsic value just prior to expiration to recoup some of the initial cost, which will reduce the loss.

Strangle

A strangle is an options strategy where the investor holds a position in both a call and put with different strike prices, but with the same expiration date and underlying asset. This option strategy is profitable only if the underlying asset has a large price move. This is a good strategy if you think there will be a large price movement in the near future but are unsure of which way that price movement will be.

Strangles come in two forms: long and short. A long strangle is simultaneously buying an out of the money call and an out-of-the-money put option. This strategy has a large profit potential, since the call option has theoretically unlimited profit if the underlying asset rises in price, and the put option can profit if the underlying asset falls. The risk on the trade is limited to the premium paid for the two options.

Conversely, a short strangle is a neutral strategy and has limited profit potential. The maximum profit is equivalent to the net premium received for writing the two options, less any trading costs. A short strangle is selling an out of the money call and an out of the money put option.

Difference Between Strangle and Straddle

Long strangles and long straddles are similar options strategies that allow investors to gain from large potential moves to the upside or downside. However, a long straddle involves simultaneously purchasing at the money call and put options.

A short straddle is similar to a short strangle and has a limited maximum profit potential that is equivalent to the premium collected from writing the at the money call and put options.

Buying a strangle is generally less expensive than a straddle as the contracts are purchased out of the money. The counter-argument to this is that since the options are out of the money, the underlying will need to make a larger price move in order for the strategy to create a profit.

Spreads

A spread option is a type of option that derives its value from the difference, or spread, between the prices of two or more assets. Other than the unique type of underlying asset – the spread – these options act similarly to any other type of vanilla option.Important to note is that a spread option is not the same as an options spread. The latter is an options strategy typically involving two options on the same, single underlying asset.

Spread options can be written on all types of financial products including equities, bonds, and currencies. While some types of spread options trade on large exchanges, their primary trading venue is over-the-counter (OTC).

Some types of commodity spreads enable the trader to gain exposure to the commodity’s production process, specifically the difference between the inputs and outputs. The most notable examples of these processing spreads are the crack, crush, and spark spreads, which measure profits in the oil, soybean, and electricity markets, respectively.

The underlying assets in the above examples are different commodities. However, spread options may also cover the differences between prices of the same commodity trading at two different locations (location spreads) or of different grades (quality spreads).

Likewise, the spread can be between prices of the same commodity, but at two different points in time (calendar spreads). A good example would be an option on the spread of a March futures contract and a June futures contract with the same underlying asset.

Spread Options Strategies

Again, spread options, which are specific derivative contracts, are not options spreads, which are strategies used in trading options. However, because spread options act as most other vanilla options, a trader can implement an options spread on spread options.

All options give the holder the right, but not the obligation, to buy or sell a specified underlying asset at a specific price at or by a specific date. Here, the underlying is the difference in price of two or more assets. Other than that, all strategies, from bull call spreads to iron condors, are theoretically possible. The caveat is that the market for these exotic options is not as robust as it is for vanilla options. The major exceptions would be crack and crush spread options, which trade on the CME Group, so the markets there are more reliable. Therefore, these combination options strategies are more available.

Using a Spread Option

In the energy market, the crack spread is the difference between the value of the refined products – heating oil and gasoline – and the price of the input – crude oil. When a trader expects that the crack spread will strengthen, they believe that the refining margins will grow because crude oil prices are weak and/or demand for the refined products is strong. Rather than buy the refined products and sell crude oil, the trader may simply buy a call option on the crack spread.

Similarly, a trader believes that the relationship between near-month wheat futures and later-dated wheat futures currently trades significantly above its historical range. This could be due to anomalies in the cost of carry, weather patterns, supply and/or demand. The trader can sell the spread, hoping that its value will soon return to normal. Or, he or she can buy a put spread option to accomplish the same goal, but at a much lower initial cost.