Two strategies directional traders can use are the straddle and strangle, both intended to capture profits from large movement in the underlying asset when you don't know which
direction the asset will move. These strategies rely on volatility, the higher the volatility the bigger the chance that the underlying will make the kind of move needed for these to profit. Speaking of volatility, the only thing we as traders can rely on is that a big move is likely to happen, the direction of the move is often questionable at best and comes down to factors out of our control. For the purposes of this discussion I will stick to long straddles and strangles.
What is a straddle? A straddle is an option position in which the trader buys a put and a call of the same strike and expiry on the same underlying. This allows the trader to profit regardless of the direction of the underlyings movement, so long as that move brings asset prices above or below the profit line. This strategy has an unlimited profit potential, so long as the asset keeps moving in one direction or the other the value of the position will continue to increase. It also has a limited risk making it safer than simple directional positions; your loss is limited to the premium of the two positions plus commissions paid.
If you are trading a position where the underlying costs $40 and the two options (assuming a straddle) both cost $100 the underlying will have to move at least $2 in either direction for the position to break even. In this case $2 represents a 5% move in the underlying, a move may have resulted in a 100% profit at expiration if only one option were purchased.
Maximum loss occurs if the underlying makes no movement at all. If the asset prices is equal to the strike price at expiration you will lose the premium paid for both the put and the call. Break even is reached when the underlying hits one of two break even points. These points are equal to the strike price plus the net premium for the position, once either of these levels is reached and exceeded profitability is reached and will go up indefinitely until expiration day.
Sometimes there may be a bullish or bearish bias to your analysis, what I mean is, volatility is high but you may see a greater chance of the move being up or down. In these instances a modified version of the straddle may be useful. It relies on the same basic structure but instead of buying puts and calls on a 1 to 1 ratio you may choose to buy 2 puts and 1 call (bearish bias, know as a strip) or to buy 2 calls and 1 put (bullish bias, know as a strap). In this case max loss occurs if there is no movement, same as with a simple straddle, but the amount of loss is compounded by the additional put or call. The profitability of this type of position is what changes most. Break even points are reached much quicker, twice as fast, when the underlying moves in the direction of bias with profits compounding twice as fast too .
Another twist on the straddle is the strangle. This is when two options positions, one call and one put, with the same expiry but different strike prices are bought on the same underlying. This strategy seeks to capture the movement of volatility markets and cuts down on the total price you must pay to enter the position. The caveats with this versus a simple straddle are that the underlying asset must move much more and that there is a greater chance of realizing the maximum loss. The upshot is that the profit potential is greater as the cost to enter is much lower.
Some Thoughts On The Use Of Straddles And Strangles
The number one benefit of using a straddle or strangle is that you do not need to correctly predict the movement of the underlying asset, effectively reducing your risk. These types of positions are especially useful during times of consolidation, periods of extremely low volatility, expected break out of technical patterns or when earnings are expected.
Break-outs of technical patterns typically result in sharp movements that come with generally accepted price targets. For example, the break of a trading range or consolidation pattern may result in a move equal to or greater than the height of the pattern. In the case of the above example if the pattern is at least $3 tall then we can safely assume that the break out will provide enough movement to generate profits in one or the other of the options positions, regardless of which way the break occurs. If price targets do not surpass the break even points on the position there is little reason to employ the strategy.
These strategies can also be used during times of extremely low implied volatility, the theory being that a period of low volatility will be followed by a period of increased volatility. Increased implied volatility can increase the value of both option positions without the movement of the underlying asset.
Cons include the price of the position, as mentioned, since it is double what you would pay for a single directional play. In theory it may seem like a good idea to use this type of option play all the time but let me assure this is not the case. The use of two offsetting positions requires a larger movement than using only one alone and that could limit or even prevent profits you might have gained otherwise.
Another negative it the exposure to time decay, straddles and strangles are two strategies that suffer most from time decay because you have theta working against you on two options at the same time. If the underlying does not make a move in a timely manner you will likely lose money regardless of when and which direction it moves in.
Final Thought - In practice it is likely that, assuming the underlying makes a large move, you will be able to sell the unprofitable leg of the position, at a loss, but for more than nothing with the result of enhancing profits on the total position.