Strangles and straddles are simple, market neutral option strategies for traders who are bullish on volatility, but unsure of where that volatility will take them.
Volatility has many investors and traders shaking in their boots. But if you understand how to employ options the right way, you know there’s no reason to run for the exit. Instead, you could use market neutral strategies as your ticket to ride this rollercoaster market.
A market neutral option strategy is one that doesn’t rely on bullish or bearish price action. Instead, market neutral strategies look to capitalize on the volatility. Depending on your outlook, there are plenty to choose from. Today, we’ll talk about how investors who are bullish on volatility should get friendly with…
Strangles and Straddles
Source: Market Rebellion
Straddles and strangles are long option strategies that involve buying both a call and a put. A straddle is when both the call and the put are at the same strike price and expiration. A strangle is when both the call and put are at the same expiration, but different strike prices.
You can buy them together as a package, however some traders prefer to “leg in” to them.
Vocab check: Legging in — A “leg” is one part of a multi-part option strategy. When an option trader “legs in”, that means they’re only buying one part of an option strategy. For instance, you might buy a long call with the intention of “legging in” to a short call later — creating a vertical spread.
A trader who wants to leg into a straddle or a strangle might buy the call leg on a red day — when the call is cheaper. Simultaneously, they might wait for a green day to pick up the put.
In any case, if you’re considering going long a straddle or a strangle, here are some things to consider:
Which strategy will better suit your needs?
As is the case with so many option trading questions, it depends on your risk tolerance! As a rule, straddles are more expensive than strangles — that’s because strangles are bought further from the money.
That means the breakeven threshold for your straddle is likely going to be lower than the breakeven for your strangle. However, you need to ask yourself, “is it worth the extra money I’m paying to be closer to the money?”
If it isn’t quite worth the money, or if you feel like the stock is about to make a very large move, you might opt instead for a strangle, allowing you to either risk less capital, or to pick up more contracts at a cheaper price.
Do you have a directional opinion?
If you opt to buy your straddle at-the-money, or your strangle equal-width apart, then these strategies are delta neutral. In short, that means you don’t have a directional opinion on the underlying stock. It could go either way, but you think the move will be big.
If you do have a directional opinion, you can adjust the strikes higher or lower depending on your directional bias. Adjusting them closer to the money on the call side will make your option strategy delta-positive. Likewise, leaving less room on the put side will make your option delta-negative. Regardless, they will always be omnidirectional to some extent. That means they can benefit from the upside and the downside — if the stock makes a large enough move.
Time is ticking
These are long option strategies, with negative theta. That means time decay hurts. When your position becomes profitable, or the move you’re expecting comes to fruition, it’s imperative that you collect profits before theta does.
You’ll want to be mindful of how many days to expiration remain on your option contract. If you have less than 14 days, you’ll want to be particularly careful — this is when the effects of theta decay begin to ramp up.
Source: Market Rebellion
Playing an Earnings Release? Be Wary of IV Crush
It’s popular to use strategies like strangles and straddles during big catalysts like earnings events — when a stock is expected to move hard in at least one direction. But if that’s your game plan, you’ll want to ask yourself questions like, “Is the expected move (the breakeven price of the straddle or strangle) greater than the average earnings move for this stock?” If it is, the option may be overpricing the potential move. If not, this may create an attractive setup for a strategy like this.
No matter what, if you’re holding long options through earnings, you need to prepare for IV crush. IV, or implied volatility, represents the expected volatility of a stock over the life of an option. Prior to an earnings event, a big question mark looms in the air, leading to higher-than-average implied volatility.
The moment the earnings event is over, you can expect a reduction in the amount of extrinsic value being priced-in to the option contract. If the stock moves far enough in your direction, intrinsic value can make up the difference. But if you’re holding a near-dated, out-of-the-money option through earnings, you’d better hope it isn’t still out of the money after earnings.
You’ll also want to look at factors like the IV Rank, which measures the currently implied volatility of the stock against its historic average. If the IV Rank is particularly high, that means you could be overpaying for the extrinsic value priced-in to the stock, at least from a historical viewpoint.
Not the only way to be market neutral
Long strangles and straddles are relatively simple options strategies. Your outlook is simple: You think the stock is about to make a big move, and you don’t really care in which direction. Your risk is defined — meaning you can only lose what you spent on the premium. And in this market, strategies like strangles and straddles represent a huge opportunity for traders who are bullish on volatility.
But these aren’t the only market neutral option strategies. If you’re ambivalent on the market and bearish volatility, you can exploit high premiums with short iron condors — by selling option spreads with defined-risk and collecting extra premium from the elevated volatility.
Or, if you’re looking to make a prediction about the upcoming rise or decline in one stock against its peers, you could use a pairs trade! Pairs trades involve taking long and short positions of the same size in two similar equities. That could be a company vs. its sector peers, like Apple (AAPL) – Get Apple Inc. Report versus the tech sector. It could be two direct competitors, like Nvidia (NVDA) – Get NVIDIA Corporation Report versus (AMD) – Get Advanced Micro Devices Inc. Report. It could even be two completely-separate assets that are sometimes grouped together, like gold versus Bitcoin!
In any case, options allow traders many different ways to make ancillary predictions on the market, without having to go the classic route of, “this stock is going up!” By learning to master straddles, strangles, and other market neutral option strategies, you can add a few new tools to your trading toolkit!