The Straddle and The Strangle
In a Daily Trader report in march 2007 we said that the tightness in the price range of Zinifex (ZFX) might provide an opportunity for an option play. In this 'Knowledge Bank' we will be revisiting the two option plays mentioned; they are the “straddle” and the “strangle”. These two strategies are ideal for profit if the short-term speculative option trader believes that a stock has been in consolidation and due to strongly break out in either direction.
Definition
- A long straddle involves simultaneously buying a call and a put at the same strike price and expiration date on the stock.
- A long strangle is simultaneously buying a call at a higher strike and a put at a lower strike in the same expiration date.
To become profitable, the underlying stock price must have a change in price greater than the total cost of the straddle or strangle, and the price change must occur prior to expiry. With a Strangle the premium paid is less - however a larger move is needed to show a profit. This can be shown in the pay-off diagram below, a Put option is bought with a strike A and a call option is bought with a strike B. (At the money is in-between A & B).
The profit increases as the price of the stock rises above B or falls below A. At expiration, break-even points will be;
Option exercise price A - premium paid for options
Option exercise price B + premium paid for options.
For each point above upside break-even or below downside break-even, profit increases by an additional point.
Straddles and strangles are multiple leg strategies and it is important to accept that one of the legs will lose money, although hopefully the other leg makes more than enough profit to compensate. Additionally, if you are certain of the bullish / bearish direction of the stock it is possible to sell out of the losing leg before expiration. This benefits as this position is a wasting asset. As time passes, the value of the position decays. If volatility increases, the rate of decay slows; if volatility decreases, decay speeds up.
Practical ExampleBelow is the daily chart of Zinifex (ZFX). As you can see, the
Bollinger Bands (please click onto link for a more detailed explanation) and the share price have been contracting into a tight range. It should be pointed out that this snapshot of the ZFX daily chart was taken before midday 27th March 2007. The share price finished sharply higher by the end of the day.
The aforementioned option strategies will make you a profit if you believe the share price will move violently in a direction once it breaks out of its tight trading range.