Straddle Option

With spreads, as we saw in our previous section, we buy and sell options with different terms (the terms of the option are the striking price, expiration date and underlying commodity).  But with straddle option, we simultaneously buy and sale options with the same terms. There are two types of straddle option choices: long straddle and short straddle.

 

Long Straddles

When you simultaneously buy a call and buy a put on the same underlying asset, with identical striking prices and identical expiration dates, you are said to be in a long straddle. You’ll profit if the underlying commodity’s price moves above or below the striking price, to a degree greater than the total costs of the options.

Short Straddles

If you simultaneously sell a call and sell a put on the same underlying asset, with identical striking prices and identical expiration dates, you are said to be in a short straddle. You’ll profit if the underlying commodity’s price does not move above or below the striking price, to a degree greater than the premiums received.
 

Examples

LONG STRADDLE

You simultaneously buy a September $3.00 call option and pay a premium of $400, and a September $3.00 put option and pay a premium of $250. Your total investment comes to $650. Assuming the underlying commodity your trading is a grain market that trades in 5,000 bushels, your $650 investment would come to 13 cents a bushel ($650 /5,000 bushels = 013.) Therefore, for this straddle to be profitable it must move beyond 13 cents in either direction.

longstraddle

 

 

 

 

 

 

 

SHORT STRADDLE

You simultaneously sell a September $3.00 call option and receive a premium of $400, and a September $3.00 put option and receive a premium of $250. Your unrealized gain comes to $650. Once again, the underlying commodity you’re trading is a grain market that trades in 5,000 bushels, so your $650 gain represents a gain of 13 cents a bushel ($650 /5,000 bushels = 013.) Therefore, for this straddle to be profitable it must remain within 13 cents in either direction from the strike price.

shortstraddle

 

 

 

 

 

 

One flaw in this strategy is that, realistically, during the life of the option it’s likely that one of the positions in your straddle will be in the money, and therefore worthwhile to exercise. If this happens, a thin margin of profit could be absorbed in commissions and transaction fees.

So, how about if we COMBINE our straddle with a spread?

This could be done in different ways. Say, for instance, we want to buy an at the money call in corn and sell an out of the money call in corn. But we want some protection in the event the market turns against us, so we additionally buy an at the money corn put and sell an out of the money corn put. This not only reduces our exposure, but increases our chances of making some profits. Though the profits may be less.

Example

December corn is currently trading at $3.00. You go ahead and buy a $3.00 corn call option which costs you 10 cents a bushel. In other words, your exposure right now is $500. To protect this investment you sell a $3.10 corn call option for 7 cents a bushel, which means you collected a premium of $350. At this point, you reduced your exposure to $150. (So far, this is a debit spread. If you recall, a debit spread is when the amount of premium you paid out exceeds the amount of premium money you received.)

But what if the price of corn drops? Well, to protect this side of the market you buy a $3.00 corn put option. Suppose it’s also going for 10 cents. That’s another $500 premium you pay. And yes, to protect this exposure on the down side you sell a $2.90 corn put option, which we’ll say is also trading at 7 cents. So you receive another premium of $350, which helps recaptures some of your investment.

Your total pay out has been $1,000, and your total collections have been $700. Therefore, your total risk is $300.

Here are the possibilities:

  1. If corn moves up to 6 cents in either direction, you’ll break even (.06 x 5,000 bushels = $300)
     
  2. If corn moves from 6 cents up to 10 cents in either direction, you’ll profit. Your maximum potential profit = $500 (.10 x 5,000 bushels = $500.)
     
  3. If corn moves beyond the 10 cents range in either direction you’ll break even. Any profit that would have been realized on the $3.00 call is given up to the buyer of the $3.10 call. Likewise, any profit that would have been realized on the $3.00 put is given up to the buyer of the $2.90 put.
     
  4. If corn moves less than 6 cents in either direction, you’ll incur partial losses. OR, if corn doesn’t move at all, you’ll lose it all. Total loss = $300.
     

We used a straddle by buying a $3.00 call option and selling a $3.00 put option. This was intermingled with our debit spread. Though we couldn’t guarantee not losing any money, with the straddle we were able to reduce our risk from the original $500 to just $300. Keep in mind, though, the price of the commodity would have to move enough to cover our brokerage fees. The key is to hedge the trade so that we spend the least amount of money possible. This could usually be done by selling further out of the money options, which is a technique called strangle. The real secret here, is to first look at the trade and see how much the total trade will cost you, and then figure out how much you can earn.

In our example, the trade cost us $300. Our maximum potential profit was $500. This is a 3:5 risk/reward ratio, which for a lot of people might not be too appealing. But suppose, instead, that we can trade with a little more leverage and can capture a larger potential profit. Let’s say we trade soybean oil, where a penny move is $6.00. In soybean oil the options are priced at 1/2-cent moves.

Therefore, purchasing a 22.50 soybean oil call for 20 cents and selling the 23.00 soybean oil call for 10 cents, allows for a potential $300 profit (50 cents x $6.00 = $300). How much did it cost us to get into the trade? Only $60 (20 cents x $6.00 minus 10 cents x $6.00 = $120 – $60 = $60.) This is a 5:1 risk/reward ratio, a bit more worthwhile than our previous 3:5 ratio.

Of course, this trade can be done in any commodity market. And the closer to expiration, the better. Again, the important thing when zeroing in on a commodity market is to look at all the possibilities. Sometimes the trade won’t work no matter what you do. Other times, it’s like looking a gift horse in the mouth. Simply pick up the paper and do the math on the front month options.Your broker can tell you exact expiration dates.

 

SHORT STRANGLE / LONG STRANGLE

When you simultaneously buy an out of the money call and an out of the money put on the same commodity and with the same expiration date, you are said to be long a strangle. On the other hand, if you simultaneously  sell an out of the money call and an out of the money put on the same commodity and with the same expiration date, you are said to be short a strangle. In both cases, the strike price is not the same.

Example 1:

It’s July 1st, and oats are trading at $2.00 a bushel. You simultaneously sell an August 2.15 call and receive a premium of $300, and sell an August 1.88 put and receive a premium of $400. This is a short strangle with a total profit potential of $700. The probability that the market price of oats will stay within your profit range in this short period of time is about 80%.

However, if the price moves in either direction beyond your profit zone, you could technically incur unlimited losses:

strangles-1

 

 

 

 

 

 

Example 2:

 It’s July 1st and oats are trading at $2.00 a bushel. You simultaneously buy an August 2.15 call and pay a premium of $300, and buy an August 1.88 put and pay a premium of $400. This is a long strangle with a total risk commitment of $700. The probability that the market price of oats may break away from your loss zone is just about 20%. However, if it does, your gain potential is unlimited:

strangle-2

 

 

 

 

 

 

          Now, let’s COMBINE a strangle with a credit spread.

Example

On May 1st the price of gold is $365 an ounce. We sell a $380 June gold

call option for $1,000 ($10 an ounce) and simultaneously buy a $390 June gold call – which is one strike price further out of the money – paying $800 for it. At the same time, we sell a $350 June gold put for $1,200 ($12 an ounce), and simultaneously buy a $340 June gold put – which is one strike price further out of the money – for $900. At this point, our credit =$2,200 for premiums collected, minus $1,700 for premiums paid. Total net credit = $500. 

This transaction is a credit spread comprised of two parts: the buying part, which qualifies as a long strangle, and the selling part which is the short strangle. Let’s examine some of the possibilities:

  1. The price of gold remains unchanged, OR moves up to $15 in either direction.
    Outcome = we make maximum profit of $500.

     
  2. The price of gold moves beyond $15 and but just below $20 in either direction.
    Outcome = we make partial profits.

     
  3. The price of gold moves $20 in either direction.
    Outcome = we break even.

     
  4. The price of gold moves beyond $20 but just below $25 in either direction.
    Outcome = we incur partial losses.

     
  5. The price of gold moves between $25 and infinity (or $25 and $0).
    Outcome = we incur maximum losses of $500.


In this example, our maximum potential gain was $500, while we limited our total potential risk to only $500 as well. The key here however, is not only having limited our potential losses, put having put the odds at our favor. Historically, bearing an unanticipated catastrophe, the price of this commodity wouldn’t swing such a large range, in such a short period of time. Thus, putting the probabilities of profits heavily on our side.

Now let’s look at a comparative chart, showing what might have happened in our previous gold example, if we had entered this trade on just a long strangle, or on just a short strangle:

 
 

       Spread/Strangle Combined     Long Strangle          Short Strangle

 

 1.         Maximum gain $500             Lose $1,700             Maximum gain $2,200

 

 2.        Make partial gains                Lose $1,700             Make partial gains

 

 3.        Break even                          Lose $1,700              Make partial gains

 

 4.          Limited losses                     Lose $1,700              Limited gains

 

 5.       Maximum loss $500            Unlimited gains            Unlimited losses

 

By this chart, it’s easy to see that as long as the market behaves the way we historically would expect, the short strangle – in spite of its unlimited risk potential – is an attractive strategy. On the other hand, if you are a risk-adverse type of person, using just only a short strangle wouldn’t be your cup of tea, since if the improbable does occur your losses could be theoretically unlimited. Therefore, by using a credit spread, you’ll take a bite out of your profit potential, but put a lid on your losses.

 

Go to Hedging Options to continue.