Say you think a stock could be due for a major breakout, but you’re not sure which direction it will take. One useful strategy is to buy a “straddle.”
A straddle involves buying both a call and a put option. The call option gives you exposure to an up move, while the put option will help you profit from a fall.
With a straddle, you use the same strike price and expiration for both options.
And lastly, you choose a strike price as close as possible to the current stock price.
For example, if a stock is trading at $100, then you’d buy call and put options with a $100 strike price.
A straddle is an important strategy to have in your toolbox. In the right setup, it’s a great way to profit from a blowout move.
But sometimes this strategy can be expensive… which can make it painful if you don’t get the move you’re looking for.
So today, I want to share a variation on the theme…
A Cheaper Option
The strategy I want to look at today is a “strangle.” It’s similar to a straddle with one major difference…
Like a straddle, a strangle uses a call and a put option with the same expiry date. But in this case, the put and call options have different strike prices.
With a strangle, you buy a call option with a strike price above the current stock price. Simultaneously, you buy a put option below the current stock price.
So for example, if a stock is trading at $100, you might choose a call option with a $110 strike price and a put option with a $90 strike price.
Because both options are out-of-the-money (OTM), that makes them cheaper to purchase.
Yet there’s a catch. The stock price has to move more before the trade turns a profit.
So let’s look at an example of how a strangle works. (Please note this is not a trade recommendation.)
A Strangle in Action
With the Invesco QQQ Trust Series 1 (QQQ) trading around $520, you decide to buy a strangle.
You simultaneously buy a QQQ $530 call option for $8 per contract and a QQQ $510 put option for $7 per contract.
So you’re paying $15 (or $1,500 since options contracts cover 100 shares) for the total strangle position.
Check out the chart below…
Invesco QQQ Trust Series 1 (QQQ)
Source: e-Signal
For you to profit from the trade, QQQ needs to move in one of two ways:
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Above $545 – that’s the call option strike price ($530) plus the cost of the combined premiums ($15).
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Below $495 – that’s the put option strike price ($510) minus the cost of the combined premiums ($15).
In contrast, a straddle with strike prices of $520 might cost around $20 (or $2,000) in combined premiums.
In that case, you’d have a $540 breakeven if QQQ rallies or a $500 breakeven if QQQ falls.
As you can see, it’s a trade-off.
The strangle is cheaper. But QQQ has to move $5 further in either direction before the trade goes into profit.
So choosing between a straddle and a strangle depends on your confidence in the size of the anticipated move.
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Understanding Risks
As with any trading strategy, you must understand the risks…
A strangle is cheaper than a straddle. But you are still paying out two lots of premium.
If the move you’d hoped for doesn’t pan out in the expected time frame, then time decay can quickly erode the value of your options.
And volatility plays an important role in a strangle as well. It affects the value of both call and put options.
So you want to buy a straddle when volatility is low but increasing. Then sell your position when volatility is high.
If volatility drops, though, you’re likely to see the value of your options tank.
The key with a strangle is to have a strong conviction that you’re going to see a BIG move – regardless of the direction.
Then let rising volatility add a tailwind to your trade.
If you get the setup right, you should be able to close out the trade for a tidy profit.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict