Straddles and Strangles

In times of uncertainty or market turbulence, investors often look for ways to profit from volatility, rather than trying to predict the direction a stock will move.

For traders, the concept of volatility itself becomes the most attractive asset to exploit.

Two popular strategies for capitalizing on price swings are long and short straddles and long and short strangles. These strategies are designed to profit from volatility, whether the stock price moves up or down. This offers a unique, if expensive, advantage in uncertain markets.

In this piece, we’ll examine the mechanics of these volatility trades — long and short straddles and long and short strangles — detailing how they work, when to use them, and their associated risks.

Understanding Volatility in the Options Market

Before we delve into the specifics, let’s set the stage with a quick primer on volatility. Volatility is the heartbeat of the market, measuring how much a stock price is expected to fluctuate over a given period. Implied volatility, derived from the prices of options, reflects market expectations about future volatility.

When volatility is low, stock prices tend to move in narrower ranges. When volatility is high, price swings tend to be larger. Options traders may take advantage of either scenario using strategies that exploit significant movements (or lack thereof) in the underlying asset’s price.

The Basics of Straddles and Strangles

Both straddles and strangles are types of non-directional options strategies. The goal here is not to predict whether a stock’s price will go up or down, but simply that it will move—hopefully, significantly. Let’s simplify them.

What’s a Straddle?

A straddle involves purchasing or selling both a call option and a put option with the same strike price and expiration date on the same underlying asset.

• Long Straddle: The trader buys both a call and a put option at the same strike price. This strategy profits if the stock moves significantly in either direction, rising sharply or falling significantly. This is known as “buying volatility.”

• Short Straddle: The trader sells both a call and a put option at the same strike price. This strategy profits when the stock price stays relatively stable, as the trader collects the premium from both options. This is known as “selling volatility.”

What is a Strangle?

A strangle is similar to a straddle but with one key difference: the trader buys or sells a call and a put option with different strike prices. The call option is typically purchased at a higher strike price than the current stock price, while the put option is purchased at a lower strike price.

• Long Strangle: The trader buys both a call and a put with different strike prices, betting that the stock will make a significant move in either direction. This strategy is typically cheaper than a long straddle because the options are further out of the money. Like a long straddle, this, too, is buying volatility.

• Short Strangle: The trader sells both a call and a put with different strike prices, hoping the stock will not move much, and the options will expire worthless. The trader profits by pocketing the premiums from selling both options. Like a short straddle, this is also selling volatility.

Now that we’ve outlined the basic structure of straddles and strangles, let’s explore the scenarios in which each strategy should be employed.

The Long Straddle: Betting on Big Movements

How it Works:

A long straddle involves purchasing both a call and a put option at the same strike price. For example, if NVDA is trading at $100, you might buy a call option with a strike price of $100 and a put option with the same strike. Your goal is to profit from a sharp move in either direction.

If NVDA skyrockets to $130, your call option will rise significantly, potentially leading to substantial profits. Conversely, if NVDA plunges to $70, your put option will be highly profitable. But remember, you paid premiums on both the call and the put, so this strategy isn’t cheap.

This strategy works well when you expect increased volatility but don’t want to bet on the direction of the price movement.

When to Use It:

Long straddles are ideal when you expect a stock to experience significant volatility but aren’t sure whether the stock price will rise or fall. This could be ahead of a major earnings report, the announcement of new regulations, or significant geopolitical events—any situation where a company or the broader market may see increased price movement. Being aware of these events gives you a strategic advantage.

Risks:

The main risk with a long straddle is if the stock price doesn’t move much. Both the call and put option could lose value, leading to a loss equal to the combined cost (premium) of buying both options. For the strategy to be profitable, the stock price must move enough to cover the premiums paid for both options.

The Short Straddle: Profiting from Stability

How it Works:

A short straddle is the opposite of a long straddle. In this case, you sell both a call and a put option at the same strike price. You’re betting that the stock won’t move significantly, allowing both options to expire worthless. You keep the premium collected from selling the options.

For instance, if you sell a $100 call and a $100 put on NVDA, and NVDA stays close to $100, you’ll collect — and keep — both premiums as profit.

When to Use It:

This strategy is ideal in low-volatility environments or when you believe the market is overestimating how much a stock will move. You’re essentially taking advantage of the market’s expectation of volatility and profiting from stability. In the world of fixed income, for years, traders sold straddles on the Fed Funds rate because they knew the Fed wouldn’t budge. They made millions off it.

Risks:

The risk with short straddles is unlimited. If the stock price moves dramatically — either up or down — your losses could be substantial. If the stock skyrockets, the call option you sold will lose value; if it tanks, the put option will lose value. Given this risk, short straddles are typically employed by advanced traders who have strong convictions about market stability. This strategy has a negative gamma. In plain English, you lose more than your model anticipates. This type of trade caused Nick Leeson to blow up Barings Bank in 1995. Beware. And be wary.

The Long Strangle: A Cheaper Bet on Volatility

How it Works:

A long strangle is a variation of the long straddle but with a twist: you buy a call and a put with different strike prices. For example, with NVDA trading at $100, you might purchase a $110 call and a $90 put. You’re still betting on volatility, but this strategy tends to be cheaper because both options are out of the money.

Profit potential arises if the stock significantly moves above $110 or below $90. The upside is unlimited, and the cost of entering the position is lower than a long straddle.

When to Use It:

A long strangle is a good strategy when you expect a big move but want to reduce your initial outlay compared to a long straddle. It’s a more budget-friendly way to play volatility, but it requires a larger move in the underlying stock to become profitable since both options start out of the money.

Risks:

Similar to the long straddle, the risk is that the stock doesn’t move significantly, and both options expire worthless. Because the options are out of the money, the stock needs to move more than it would in a straddle for the position to become profitable.

The Short Strangle: Limited Volatility, Limited Profits

How it Works:

A short strangle involves selling a call and a put with different strike prices. For instance, you might sell a $110 call and a $90 put on NVDA if it’s trading at $100. As with the short straddle, you’re betting that the stock won’t move significantly, and you collect the premiums from selling both options.

Because the options are further from the current stock price, this strategy has a wider profit range than a short straddle, though the premium collected is smaller.

When to Use It:

A short strangle is ideal in scenarios where you expect limited volatility but want a margin of safety. You’re still betting on stability but with less risk than a short straddle. It’s a common choice for traders in range-bound markets or when implied volatility is unusually high.

Risks:

Like the short straddle, a short strangle carries significant risk. If the stock moves significantly, you’ll incur losses on either the call or the put, depending on which direction it moves. However, because the strike prices are further apart, the potential for significant losses is reduced compared to a short straddle.

Wrap Up

It’s incumbent upon me to tell you that I never sell options unless I’m closing a long options position. But I also want to show you the markets, and these trades play an important part. Many traders sell options profitably… until they don’t.

However, volatility trading provides a versatile approach to navigating uncertain markets through strategies like long and short straddles and strangles. Whether you’re looking to profit from sharp price movements or betting on calm, range-bound trading, these strategies offer a way to trade on volatility without needing to predict the direction of price changes.

But they also come with unique risks. Long strategies require enough movement to cover the cost of premiums, while short strategies expose you to potentially unlimited losses. Knowing when to use each strategy — and carefully managing your risk — helps turn uncertainty into opportunity.

As always, these options strategies require a solid understanding of the risks involved and a well-timed approach. Stay sharp and watch the markets carefully — because in volatility, the only certainty is uncertainty.