Option strategies the straddle and the strangle
Straddles and Strangles basics
A strangle or a straddle are similar trading strategies which are both non-directional and volatility based. What i mean by non-directional and volatility based is that if the stock moves the option should become more valuable and it does not matter whether it moves up or down. Now that seems pretty darn cool because a person can make money whether the stock goes up or down. Sorry guys it does not work that way. I will explain the phenomenon and what we will want to learn is when this is a good strategy to use and when it is not a good strategy to use.
I am assuming that anyone who is reading this already knows what put and call positions are.
Lets find out what straddles and strangles are:
Straddle: This is buying a combination of a call and a put at the same strike price (A straddle can be written but anyone who employs this must be a very advanced trader because this is considered one riskiest positions by brokerages so a person needs a lot of experience as well as capitol to trade these positions). These are usually bought right near or at the money. For example if a stock is at $30.50, a straddle would consist of a $30.00 strike price put and a $30.00 strike price call. The call would be $.50 in the money and the put would be $.50 out of the money. Now this could be bought where one option is fairly deep in the money and another is out of the money but I would have to say this is a very poorly constructed position in my opinion so I wont discuss it.
Strangle: This is buying a combination of a call and a put with different strike prices. These positions are typically bought approximately the same amount out of the money. . An example of this would be the same $30.50 stock with a $35.00 call and a 25.00 put. The call would be $4.50 out of the money and the put would be $5.50 out of the money. If the put and the call are at a different amount out of the money, this is called a biased position. To bias this on the call side we would buy a $32.50 call and a $25.00 put. The call would then be $2.00 out of the money and the put would be $5.50 out of the money. A bias in this case means that a person believes that the stock will move more one way than the other.
The biggest differences between a straddle and a strangle are the cost of the positions and how far the stock needs to move to produce a profit. Because a straddle has options that are at money, both the put and the call will be much more expensive than the put and the call in a strangle. A straddle typically starts becoming more valuable with smaller movements than a strangle. (We will observe this in a future post)
So why was my original statement cautionary on these positions? Shouldn't they make money as a stock moves?
What happens with a little bit of movement is the delta of the put and the call are the same. In lay terms, this just means that as one option becomes more valuable the other option in this position loses money and they do it at the same rate. A typical retail investor will buy the position at ask and sell bid so they have already lost the spread so a position needs to move to at least cover this spread. This becomes compounded by both positions losing money with time decay.
This is a bad position when the stock loses implied volatility. I know I am using big words but lets break this down. If the market has a high expectation for a stock rise it is said to have a high implied volatility. This expectation causes the options to be very expensive. Yes this brings up a get rich quick scheme by investing right before earnings are announced for a stock. Everyone expects the stock to make a large movement. Options are super expensive when there is a high implied volatility and most of the time the stock doesn't move as much as expected. This nice strategy of catching a big movement is flawed and causes people to lose money.
There is a time and a place for trading straddles and strangles like low volatility times. When investing into certain technical patterns such as pennants (draw a line from the tops and the bottoms with the point on the right hand side of the graph), money can be made. As a stock consolidates it becomes less volatile so the premiums will become cheap. In this period money can be made if the stock breaks out in the assumed time frame. There are also stocks that can be god straddle investments through earnings and money can be made if a person understands the option contracts underlying the stock. I am going to post some prices of stocks and we will follow some strategies and that is the best way to learn. It is very hard to see what happens without a functional understanding of how different options behave.
"This is one of the so called wonder strategies that will make you millions". Understand it for what it is..............It is a volatility methodology with a big dead zone in the middle. Money is not made with small movements.
To drive this point home we are going to observe some options on stocks and we are going to watch the stock move and watch the value of the option positions. I am doing for you what you should do before you trade options and that is to have a feel for how they move with the movement of the underlying stock by observing before trading.
I am not going to make this real long so there will be a couple of follow up posts on the long strangle and the straddle. There are many other volatility methods that I will introduce like backspreads, butterflies, condors, etc.
We will observe and learn together.
Please note: This information is for educational purposes only.