Back to top

Image: Bigstock

If You Liked the Straddle, You Should also Consider a Strangle.

Read MoreHide Full Article

Three weeks ago, we discussed the Straddle – in which we would buy a call and a put simultaneously with the same strike and the same expiration date.


The intention was to capitalize on the recent drop in implied option volatilities from levels above 80% during the worst of the Covid-19 market selloff to under 30%.


Generally, as stock prices rise, implied volatilities fall, but that hasn’t necessarily been the case in the VIX over the past week.


Since last Thursday, the broad markets have continued to rally, but the VIX is still near 28%.
That’s good news for a straddle we considered buying back then – we got the benefit of more than $20 worth of price action from a move in the underlying stock, but with implied volatilities holding up, our long options are also holding their value well.  


Just like three weeks ago, there’s considerable uncertainty about the likely direction of the broad markets. Many believe that the recovery has brought us “too far, too fast” and that a second wave of viral infections is possible as the country reopens. Others point to unprecedented fiscal and monetary stimulus as a likely driver of continued recovery in equity prices.


If we were going to initiate a new trade now, it might make sense to instead consider a different spread – the “Strangle.”


The Strangle is a very similar trade to the Straddle in that we’re buying one call and one put with the same expiration date, except that we use options that are both out of the money, so they don’t share the same strike.


It’s less expensive than a Straddle, but we also have to be more correct to get a big payoff. It also has the benefit of having completely defined risk. Do you think there’s a possibility that the S&P 500 might move 3% or more over the next 22 days?


I do.


Example:


We buy a strangle on the SPY ETF with a June 20th expiration. With SPY trading at $305/share, we buy the 295 put for $4.00 and the 315 strike call for $2.25. Those are implied volatilities of 30% and 19%, respectively.


Our breakeven prices are $288.75/share and $321.25/share. Based on some of the moves we’ve seen lately, both of those prices certainly seem possible.
Also, just like the straddle, we would benefit from an increase in implied volatility even if the shares don’t move right away.


At-the-money implied volatility is around 22.5%.  If implied vol rose to 30%, each option would gain in the neighborhood of $0.90. (Depending on the slope of the volatility skew, the put would probably rise more than the call, though that’s not mathematically certain.) We’d have an immediate profit of about $1,800 if we sold after that move in implied volatility even if the shares didn’t move – but we would have to sell our Strangle to lock it in.


Just as was the case with the straddle, if we get a big move in either direction, we can sell the half of the trade that’s seen price appreciation and keep the other half in the hopes of a swift reversal.
All in all, a Straddle and a Strangle are very similar trades. A Strangle is less expensive to buy in the first place, but you have to be more correct about the timing and magnitude of a move in the underlying for it to pay off.


As volatilities hover near multi-month lows – but also still justifiably above pre-Covid-19 averages – it’s probably a good idea for an enterprising options trader to consider both the Straddle and the Strangle.


-Dave

Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.

Interested in strategies with profit potential even in declining markets? Maybe our Short List Trader service is for you.

Want more articles from this author? Scroll up to the top of this article and click the FOLLOW AUTHOR button to get an email each time a new article is published.



 


In-Depth Zacks Research for the Tickers Above


Normally $25 each - click below to receive one report FREE:


SPDR-SP 500 TR (SPY) - free report >>

Published in