Strangles and straddles are options strategies which are available to investors. These options allow the investor to gain from a significant move which occurs either upward or downward with the price of a stock.
Both strategies require the investor to purchase an equal number of call and put options that have the same expiration date.
The difference between strangle and straddle options is that a strangle will have two different strike prices, while the straddle will have a common stock price.
Now let’s put you into the shoes of the investor. This will help you be able to better understand what the benefits and risks of both strategies happen to be.
The Difference Between a Strangle and a Straddle
Let’s say that you are very interested in a company called XYZ Enterprises. You know that the company is going to be releasing its earnings results in the next 3 weeks. Do you know if the results are going to be good? Or will they be bad?
You don’t know. That’s why now is a good time to enter into a straddle option. When the earnings results are released, then there is an excellent chance that the stock will move sharply upward or sharply downward.
Now let’s use a price of $15 for the stock of XYZ Enterprises as part of our example. We’re going to say that the call option for when the earnings report is due will be $2, while the put option is going to be $1.
When you elect for the straddle option, you’re going to be purchasing both. That means you have a cost of $3 per share for the options. If you purchase 200 shares per option contract, your cost is now $600 for the investment.
Your straddle will increase in value if the stock moves in either direction. Because you’ve spent $3 for the option ($2 for the call and $1 for the put), a movement of more than $3 in either direction will generate profits for the investor.
The benefit here is clear. A straddle option has no directional bias. As long as the stock movement is large enough to cover the costs of both options, the investor is going to make some money.
If the investor believes with certainty that the price of a stock will move upward or downward sharply, in a specific direction, then a strangle option is the better choice. It gives you less downside protection, allowing you to create more profits if the movement goes in the direction expected.
Let’s say the call option is still $2 and the put option is still $1. Using the strangle option, you would look to buy at a lower strike price that has a lower put cost if you believe the earnings results will send the stock price upward. If you purchase the put option at $0.50 instead of $1, then your breakeven costs are going to be lower, which means you need less of an upward move to reach profitability.
At the same time, you’re still guarding against a sharp movement in the other direction because you’ve still got the put option on the table.
How Do Stock Options Work for Investors?
Strangles and straddles are options contracts. They are basically what the price probability will be for a future event with the stock in question. When there is a strong likelihood that something will occur, the most expensive option will be the one that is most likely to profit from the future event.
Using the example from above, if the call option is $2 and the put option is $1, then investors believe that XYZ Enterprises is more likely to make money than lose money.
You do have the option to purchase the call option or the put option by itself. If you purchase the 200 shares with the $1 put option, your cost would be $200 instead of $600 as it would be if you took a straddle. That means the stock must slide more than $1 per share for you to earn profits.
The risk here is that if the company earns money, you’re going to lose your investment.
And if you went with the call option only and the stock price went down, you could potentially lose $400.
So, let’s take a look at a standard call option now using a real-world example.
At the time of this writing, shares of Apple (AAPL) are trading at $216.18. Using a generic call option, let’s say the strike price is $240 and the option expires in 3 months.
The call option gives you the ability to purchase shares of Apple at $240 during any time over that 3-month period at the $240 price. It is not an obligation to do so. If the price of the share goes above $240, then you get a win. If not, then you’re just out the price of the option that you purchased.
Why do you win? Because you’re holding an options contract that is worth more money.
Let’s say the options contract for AAPL at $240 comes with a premium cost of $5. In the United States, exchanges will usually sell option contracts in lots of 100 shares. That means you’re purchasing the right, not the obligation, to purchase shares at $240 by the expiration date on the contract.
Let’s say you decide to purchase 3 blocks, which will cost you $1,500 in total. Before the call option contract is worth anything the stock of Apple must climb above $240.
Now go forward 6 weeks. Let’s say AAPL shares are trading at $250. Now the options contract price has climbed to $9.00 for each 100-block. Since you own 3 blocks, you could sell those options for $2,700. That means you’ve got $1,200 profit to consider.
If you took a straddle, you would then use a put contract to guard against losses. Let’s say the put contract option puts the strike price at $200. You purchase 1 block of 100 at a cost of $2.50, since the market likes the chances of Apple stock going up in price.
When the price goes up to $250 and the put option expires, you’re down the $250 it cost you to purchase the contract because it is now worthless. If the price goes down, however, you could still recover your losses from the call option.
Let’s say AAPL goes down to $180 in those 6 weeks instead. The value of your put option goes up, which means you can close that option to generate profits, even though the call option might be worthless.
This gives you an effective way to guard against losses when you’re investing.
Finding the Sweet Spot Between the Options
Now here’s the beautiful thing if you’re an investor. It is possible, with a stock that has a volatile pricing history, to profit from both the call and put options. All you need is enough movement within the stock price within the valid time of the contract to give yourself a chance at gaining profits.
Just because you sell one set of options doesn’t mean you must sell both sets of options when you choose to straddle or strangle. You can sell one and hold onto the other until it becomes profitable or it expires. The option is going to be worthless until the stock hits the strike price anyway.
That’s why it is important to research stock history as an investor if you are looking for ways to invest without actually investing into shares of the company. Using options for investment makes it easier to get involved with a lower income level. The downside, however, is that you’re taking on much more risk.
Here’s why. Let’s go back to our example with XYZ Enterprises. The strike price is $15 for the call and $12.50 for the put. If the earnings report causes the stock price to stay where it is at $13.50, both of your options are going to be worthless. If you had put that money into the actual stock, you would be able to at least keep your value.
That is why the stock market is often referred to as the ultimate casino. You have the chance to make big profits. You also have the chance to lose everything if you make the wrong decision. For that reason, this guide should be used for informational purposes only.
This is not a recommendation for AAPL stock. It only served as a real-world example to explain how options work.
Before making an investment, be sure to evaluate all of your options, your potential gains, and any losses you might incur. If you have any questions about a specific stock or the performance of your portfolio, then be sure to speak with a professional investment advisor before choosing to straddle or strangle.