The explosion of interest in options trading since 2020 has seen option volumes skyrocket as new day traders are increasingly substituting trading stocks for trading options. However, the primary use of options for less experienced traders is to express a short-term directional market view with extreme leverage (such as either a long call or long put). Whilst options are ideally suited to this purpose, this ignores the power of options which can be combined to express more nuanced views of the market – such as market neutral positions where traders are not betting on the market’s outright direction but on other market dynamic’s such as the market’s volatility.
At FirstRate Data we see more experienced traders use historical options data for developing market-neutral trading strategies, the two most basic of which are Strangles and Straddles. In addition to trading applications, market-neutral options combinations can be used to improve the hedge effectiveness of a commodities hedging position by counteracting volatility.
The straddle strategy involves the simultaneous purchase of both a call option and a put option with the same strike price and expiration date. This strategy is ideal when a trader anticipates a significant price movement but is uncertain about the direction, such as when a trader anticipates an earnings surprise or believes the market is underestimating the potential for an earnings surprise.
Mechanics of the Straddle:
Buy Call Option: By purchasing a call option, the trader gains the right to buy the underlying asset at the strike price, and so this position benefits from an upward price movement.
Buy Put Option: Simultaneously, the trader buys a put option, which grants the right to sell the underlying asset at the strike price, this position benefits from a downward price movement.
Advantages of the Straddle Strategy:
Limited Risk: The maximum loss is limited to the combined premium paid for both options.
Profit Potential: If the price moves significantly in either direction, the potential for profit is substantial.
Protection Against Volatility: The strategy capitalizes on volatility, making it suitable for events such as earnings announcements or major news releases.
Disadvantages of the Straddle Strategy:
High Breakeven Point: Due to the cost of purchasing two options, the combined premium is relatively high, requiring a significant price movement to become profitable.
Time Decay: As time passes, the options’ values will erode due to time decay, impacting the overall position.
The Strangle Strategy:
The Strangle is similar to the Straddle in that it is a bet on increased volatility. However, unlike the Straddle, the strike prices are different which allows the trader to express some limited view on the directionality. Therefore, if a trader expects increased volatility as well as a decline in the price then a Strangle would be suitable.
Similar to the straddle, the strangle strategy involves buying both call and put options. However, with the strangle, these options have different strike prices, accommodating a larger price range.
Mechanics of the Strangle:
Buy Call Option: The trader purchases a call option with a higher strike price.
Buy Put Option: Simultaneously, a put option is bought with a lower strike price.
Advantages of the Strangle Strategy:
Lower Cost: Compared to the Straddle, the Strangle strategy has a lower initial cost due to the use of out-of-the-money options.
Wider Breakeven Range: The wider range between the two strike prices provides more flexibility for the price to move before the position becomes unprofitable.
Potential for High Returns: If the price movement is substantial, the profit potential can be significant.
Disadvantages of the Strangle Strategy:
Higher Breakeven Points: Despite the wider range, the price must still move considerably to overcome the combined premium and become profitable.
Risk of Limited Movement: If the price doesn’t move significantly, both options can lose value due to time decay.
Choosing Between Straddle and Strangle:
The choice between these strategies depends on the trader’s market outlook and risk tolerance. If there’s an expectation of a substantial price movement, but the direction is uncertain, the straddle might be more suitable. However, if the trader is comfortable with a wider price range and seeks a lower initial cost, the strangle could be the preferred choice.