STRADDLES, STRANGLES AND BUTTERFLIES

Straddle, strangle and butterfly strategies each offer very interesting risk/profit
profiles and various outcome possibilities. If you know some of the option
trading fundamentals, market dynamics and technical parameters about options
(such as greeks, time decay, volatility etc.) it might be beneficial to acquire
knowledge about some of the more advanced strategies out there and the
opportunities they may offer.

Straddle Strategy

Straddles

 

Straddle is a non-directional option strategy that can
be created by simultaneously buying a call and a put option on the same
underlying security, with the same strike price and the same maturity date.

 

Straddle is a very interesting strategy that will only
be profitable if the underlying price goes up or down more than the cost of the
strategy. Cost of the strategy can be calculated by the cost of each option
premium that’s required to create the strategy.

You can also see from the graph that upside of this
strategy is theoretically limitless.

Example:

 

Let’s say Uber stock is trading at $35 in January. An
options trader enters a long straddle strategy. The strategy can be constructed
by buying put options and call options both with strike price of $35. Let’s say
options also have an expiry date in 2 months in March and cost $200 each. Total
strategy cost is $400.

·        
At the expiration date, if the stock is up and trading at $45,
put will expire out of the money and will be valueless. Call option, however,
will be worth (45 – 35) x 100 = $ 1000.

Total profit is 1000 – 400 = $600.

 

·        
At the expiration date, if the stock is down and trading at $25,
call will expire out of the money and will be valueless. Put option, however,
will be worth (35 – 25) x 100 = $ 1000.

Again, total profit is 1000 – 400 = $600.

 

·        
Here is the worst scenario for the strategy. At the
expiration date, if the stock is perfectly sideways and still trading at $35,
call will expire out of the money and will be valueless. Put option will also
expire worthless.

Total loss will be the cost of the strategy: $400

 

·        
On the other hand, we can calculate the breakeven points for
the strategy to turn profitable. Simply $400 profit is needed to counter for
the cost that was needed to enter the strategy.

With an option multiplier of x100, $400 can be made
with 400/100 = $4 difference in either direction.

So, if the underlying stock rises to $39 or drops to
$31, this strategy will be at breakeven (no loss, no profit) and anywhere
outside that range of $31 – $39 this straddle strategy will start to be a
profitable strategy.

From this example, as you can tell, straddle is not a
strategy that likes a flat market, but it thrives when there is enough movement
on either direction.

Strangles

 

            Strangle is a strategy that resembles straddle with a tiny difference. Instead of maximum loss being a unique value, in a strangle strategy maximum loss happens through a range of underlying security prices.

            How is this different behavior achieved? Simple. While straddle is constructed by buying a call and put option with the same strike price, strangle is created by buying call and put options with different prices that allow this behavior.

 

             Let’s see an example to make it clearer.

Strangle Strategy

Example:

 

 

Let’s say Uber stock is trading at $35 in January. An
options trader enters a long strangle strategy. The strategy can be constructed
by buying call options with a strike price of $40 and put options with a strike
price of $30. Let’s say options also have an expiry date in 2 months in March
and cost $75 each. Total strategy cost is $150.

·        
At the expiration date, if the stock is up and trading at $45,
put will expire out of the money and will be valueless. Call option, however,
will be worth (45 – 40) x 100 = $ 500.

Total profit is 500 – 150 = $350.

 

·        
At the expiration date, if the stock is down and trading at $25,
call will expire out of the money and will be valueless. Put option, however,
will be worth (35 – 30) x 100 = $ 500.

Again, total profit is 500 – 150 = $350.

 

·        
Here is the worst scenario for the strategy. At the
expiration date, if the stock is perfectly sideways and still trading at $35,
call will expire out of the money and will be valueless. Put option will also
expire worthless.

Total loss will be the cost of the strategy: $150

 

From this example as you can tell strangle is very
similar to straddle and is not a strategy that likes a flat market, but it
thrives when there is enough movement on either direction. It is created with
using call and put options with two different strike prices. Its downside is
less than a similar straddle strategy however, the range of the downside is
wider.

Butterflies

 

Butterfly may look like the inverse version of
straddle strategy on the graph, however there is a significant difference:
limited downside. It’s different than straddle’s limitless upside which is an
advantage as limitless downside strategies can be very difficult to manage and
very costly when market view turns out wrong.

Unlike straddle and strangle butterfly is a strategy
that thrives in flat market and doesn’t like directional movement on both
sides. Fortunately, though, maximum loss will flat out at a certain value on
both directions.

Butterfly Option Trading Strategy

 Let’s see an example to make things clearer:

EXAMPLE:

Let’s say Uber stock is trading at $35 in January. An options trader
enters a long butterfly strategy. The strategy can be constructed by writing 2
call options with a strike price of $35 and buying 2 call options with strike prices
of $30 and $40.

Basically, we can say that butterfly strategy is created by buying a call
spread and selling appropriate amount of at the money call options.

Hypothetically let’s say 2 calls written and sold at the money were $3
each and investor collected a total of $300 + $300 = $600 premium with an
option multiplier of 100x. Also let’s say call with a strike price of $30 was
$7 and call with the strike price of $40 was $1. So, the total cost at the
entry for the strategy is: $600 – ($700+$100) = $200 total.

  • At the expiration date, if the stock is still $35, the strategy will be
    profitable. Calls that were at the money will expire worthless and call with
    the strike price of $40 will expire worthless. Call option with strike price of
    $30 will be worth $35 – $30 = $5 x 100 = $500 minus your cost for the
    strategy’s net premium: – $200
    $500 – $200 = $300.
  • At the expiration date, if the stock price falls below $30 or rise above $40 the
    strategy will recur maximum loss which is the cost to enter the position: $200

From this example as we can tell butterfly is a strategy that likes a flat
market, but it doesn’t do well when there is a significant movement in either
direction.

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