Straddle and strangle: options for large price moves

Straddles and strangles are options strategies for large price moves whose direction is uncertain. Someone who buys them only makes a profit at expiry if the price moves by more than the two options cost. With a straddle, both options have the same strike price. With a strangle, they have two different ones. When sold, the profit is limited to the premium received, and the risk of loss is theoretically unlimited. The basics of individual options are covered in the article Options explained simply: calls and puts by example.

What is a long straddle?

With a long straddle, a call and a put are bought with the same underlying, strike price and expiry. If the price rises sharply, the call gains in value. If it falls sharply, the put does. At expiry, at most one of the two options still has value, and it has to recover the cost of both.

At expiry, the loss is limited to the two premiums. It is greatest when the price is exactly at the strike price, because both options then expire worthless. The profit is open-ended on the upside. On the downside it ends at a price of zero. Drawn as a chart, this forms a V.

Long strangle: cheaper, but with wider thresholds

With a long strangle, a call and a put with the same expiry are also bought, but the call has a higher strike price than the put. As a rule, today's price lies in between, so neither option would pay out immediately. Specialists say they are ‘out of the money’. A strangle therefore usually costs less, but the price generally has to move further.

In the example, the strangle costs a third of the straddle, but the zone in which the entire premium is lost is wider.

Where are the break-even points?

The break-even point is the price at expiry at which there is neither a profit nor a loss. Straddles and strangles each have two of them. With a straddle, they lie at the strike price plus and minus both premiums, in the example at 106 and 94. With a strangle, the call's strike price counts on the upside and the put's on the downside: 105 + 2 = 107 and 95 − 2 = 93.

The calculator shows both examples and the short straddle, meaning the same straddle sold.

How to read the chart, using the long straddle as an example:

1. The horizontal axis shows the price at expiry, the vertical axis the profit or loss per share.
2. The lowest point is at 100, at a level of −6.
3. At 94 and 106, the line crosses the zero line. Circles mark these break-even points.
4. Beyond them, the line rises, to +9 each at 85 and 115.

With the long strangle, the bottom is flat: from 95 to 105, the line stays at −2. The short straddle is the mirror image, with its peak at +6.

Values per share from the examples above, excluding fees.

Straddle and strangle before expiry: time value and volatility

Before expiry, time and expected fluctuation also matter. The premium consists of intrinsic value and time value. Intrinsic value is what exercising the option would bring immediately. Time value is a kind of price for the chance that something will still happen before expiry. It is greater the longer the remaining term and the higher the volatility, that is, how widely the price fluctuates.

With a long straddle and a long strangle, two options lose time value at the same time. Every day without a significant move therefore costs time value on both options. This loss in value is measured by theta, as the article Option Greeks explained simply shows.

The second force is implied volatility, meaning the fluctuation the market prices into options. If it rises, both options become more expensive, which helps the buyer. If it falls, both lose value. The background is explained in the article on how volatility affects option prices.

Why a straddle can lose money despite a price jump

Some events are announced in advance, such as quarterly results. Beforehand, implied volatility can rise because the market prices in a price jump on the announcement date. Once the news is out, this component disappears and implied volatility can fall markedly. This is known as an ‘IV crush’, where IV stands for implied volatility.

A study by Leung and Santoli (Columbia University, 2014) describes this pattern. In their case study, the implied volatility of an equity option rose from around 20% to around 70% ahead of the announcement. It then fell back to close to 20%. This is a single case, and past developments are not a reliable indicator of future results.

Short straddle and short strangle: small premium, large risk

With a short straddle, the same two options are sold instead of bought. With a short strangle, it is a call and a put with different strike prices, usually both out of the money. The premiums received are the maximum possible profit, in the example 6 for the straddle and 2 for the strangle.

The result is the mirror image of the buyer's side. A loss arises as soon as the price moves away from the strike price by more than the premiums received. With a strangle, the distance is measured from the strike price of the call or of the put. On the upside, the loss from the sold call grows without a fixed limit. On the downside, the loss from the put grows until the price reaches zero. Rising implied volatility works against the seller.

The risk disclosure document of the US options exchanges and their clearing house OCC (Options Clearing Corporation, June 2024 version) also describes the risk of selling a straddle as unlimited. The Swiss Bankers Association writes in its risk brochure (November 2019 version): ‘From the seller's point of view, the risk of loss on a call option is even unlimited.’

Someone who sells options must post collateral, known as margin. If it is no longer sufficient, the bank or broker can demand additional funds (a margin call). If these are not provided, the position can be closed unilaterally. With a short strangle, rising volatility can increase the requirement even if the price stays the same. The loss can far exceed the collateral.

Risks and limits

All four variants can cost money. The buyer's side limits the loss but does not prevent it. The calculator only shows expiry, excluding fees and taxes.

• Long straddle and long strangle: If the price at expiry is at the strike price or between the strike prices, the entire premium is lost. The risk grows the further out of the money the options are and the shorter the remaining term.
• Short straddle and short strangle: The loss is theoretically unlimited, and there are also margin calls and a possible forced close-out. According to the OCC, uncovered option writing is only suitable for experienced investors: people who understand the risks, have sufficient liquid funds to meet margin requirements and can bear substantial losses.
• Exercise at an inopportune time: American-style options can be exercised at any time up to expiry. If one side of a sold position is exercised and the other is not closed, losses on both sides are possible.
• Two transactions: Fees are charged on each option. It may be impossible to trade both options at the same time at the desired price.
• Closing before expiry: Exchange-traded options can be closed early with an offsetting transaction (selling the options bought, buying back the options sold), as long as there is a market for them. This is not guaranteed.
• Warrants: A warrant (an Optionsschein in Germany and Austria) is an option in the form of a security. The option writer is always the issuer, that is, the institution that issues it. Investors can buy warrants and sell them again, but cannot sell them as option writers themselves. As a result, only the buyer's side can be replicated, with the risk that the issuer defaults.

Conclusion

When bought, straddles and strangles only make a profit if the price at expiry passes one of the two break-even points. In the example, the strangle costs less but needs the larger move. Loss of time value and falling volatility work against the buyer, and the premium can be lost in full. When sold, the profit of both variants is limited to the premium received, and the risk of loss is theoretically unlimited.