What are Straddles and Strangles?

A call option is the right to buy a given asset at a fixed price on or before a specific date. A put option is the right to sell a given asset at a fixed price on or before a specific date. Calls increase in value when the price of the underlying asset goes up; puts increase in value when the price of the underlying asset goes down. Straddles and strangles are options trading strategies that combine both puts and calls to create positions that do not depend on the direction of the market movement for their profitability.

A long straddle position is constructed by purchasing both a put and a call at an exercise price at or near the current price of the underlying asset. To become profitable, the underlying must have a change in price greater than the total cost of the straddle, and the price change must occur prior to expiry. If it doesn't, the straddle expires worthless. Since a straddle can never be worth less than zero, long straddles have limited risk and unlimited profit potential.

A short straddle position is constructed by selling both a put and a call at an exercise price at or near the current price of the underlying asset. Because the options are sold rather than bought, the position is initially as profitable as it can be. To remain profitable at expiry, the underlying price must move less than the combined price obtained by selling the straddle. Short straddles carry unpredictably large risks and limited profit potential.

A long strangle position is constructed by purchasing both a put and a call at exercise prices some distance from the current price of the underlying asset. In terms of profit and loss, it acts very much like a long straddle. The advantage over straddles is that it costs less, and therefore has a lower maximum possible loss. The disadvantage is that it requires an even larger move to become profitable.

A short straddle position is constructed by selling both a put and a call at an exercise price some distance from the current exercise of the underlying asset. It has the same limited-gain, unlimited-loss characteristics as a short straddle, but it requires a greater price change for the position to lose money.

As a general rule, traders prefer to sell straddles and buy strangles when the expiration date is far in the future; conversely, they prefer to buy straddles and sell strangles when expiration is in the near future.