Straddle and Strangle

Options trading is a wild and crazy part of the financial markets where you can manage risk and make returns. Among the strategies you can use to do that are straddle and strangle. They allow you to play volatility without having to predict the direction of the market. This article will go into the details of these two strategies, the mechanics, benefits and risks and how they are used in finance and accounting.

Options: A Quick Primer

Before we get into straddle and strangle, let’s first understand options. An option is a financial derivative that gives the holder the right but not the obligation to buy or sell an asset at a set price within a set time frame. There are two types of options: calls and puts. A call option allows you to buy an asset, a put option allows you to sell an asset.

The Straddle

Definition and Mechanics

A straddle is buying both a call and a put on the same underlying with the same strike and same expiration. This is used when an investor expects big volatility in the underlying but is not sure which direction the price will move.

• Long Straddle: In a long straddle you buy both the call and the put. This makes money if the underlying moves big in either direction.
• Short Straddle: In a short straddle you sell both the call and the put. This makes money if the underlying doesn’t move much.

Example

An investor buys a long straddle on XYZ stock which is trading at $100. He buys a call with a strike of $100 and a put with the same strike, both expiring in a month. The total cost of the straddle is the sum of the two option premiums.

If XYZ stock moves big above or below $100 the investor makes money. For example if the stock goes to $120 the call will be worth $20 and the put will expire worthless. If the stock goes to $80 the put will be worth $20 and the call will expire worthless.

Risks and Rewards

• Risk: Biggest loss if the underlying stays at the strike at expiration and both options expire worthless. This is capped at the total premium paid.
• Reward: Unlimited as there is no cap on how high or low the underlying can move.

The Strangle Strategy

Definition and Mechanics

A strangle is buying a call and a put on the same underlying, but different strikes. The call has a higher strike than the current market price and the put has a lower strike. This is used when an investor expects big volatility.

• Long Strangle: In a long strangle you buy both the call and the put. This makes money on big moves.
• Short Strangle: In a short strangle you sell both the call and the put. This makes money if the underlying is in a range.

Example

An investor buys a long strangle on XYZ stock which is trading at $100. They buy a call with a strike of $110 and a put with a strike of $90, both expiring in one month. The total cost of the strangle is the sum of the two option premia.

If XYZ stock moves big above $110 or below $90 the investor can make money. For example if the stock goes to $120 the call will be worth $10 and the put will expire worthless. If the stock goes to $80 the put will be worth $10 and the call will expire worthless.

Risks and Rewards

• Risk: The max loss is if the underlying is between the two strikes at expiration and both options expire worthless. This is limited to the total premium paid for the options.
• Reward: The potential profit is unlimited, same as the straddle.

Finance and Accounting

Hedging and Risk Management

Both straddle and strangle are useful tools for hedging and risk management. Investors can use these to protect their portfolios from big market moves. For example a company expecting big news or events that could impact their stock price might use a straddle or strangle to hedge against potential negative price moves.

Speculation

Traders who expect high volatility but don’t know the direction can use these strategies to play price moves. This is useful during earnings, economic data, or geopolitical events.

Portfolio Diversification

Adding options strategies like straddle and strangle to your portfolio can add diversification. These strategies give you exposure to volatility which can be good when traditional asset classes like stocks and bonds are not performing.

Options Accounting

From an accounting perspective options need to be recorded and reported in financial statements. The premium paid for buying options is an asset, the premium received for selling options is a liability. The value of the options needs to be adjusted periodically to reflect the market value and any gains or losses from options trading is recorded in the income statement.

Conclusion

Straddle and strangle are powerful options trading strategies that allow investors to profit from volatility without needing to predict the direction of market movements. While they offer significant potential rewards, they also come with inherent risks that must be carefully managed. Understanding these strategies and their applications in finance and accountancy can help investors make informed decisions and effectively navigate the complexities of the financial markets.