Dr. Ken Rietz
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This month’s spreads commentary is most focused on trading rather than hedging, and it is bit more advanced than most previous ones. It is about straddles and strangles, two very similar strategies, and often confused with each other, even by some professionals. I will explain both, including when to use each, and then I will give ab example of each. First, what are straddles and strangles? Both of them involve Buying one put and one call, on the same ticker and with the same expiration date. With a straddle, the strike prices are the same, but with the strangle, the strike price for the call is larger than the strike price for the put. The resulting profit graphs for the two are shown here (at the precise expiration date and time): |
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When do you use straddles or strangles? Since you start on each one at the bottom middle, there are loss prices you have to get out of. Therefore, you use these only when you expect a large move either up or down. These strategies lose a lot of money if the price goes nowhere. An example in stocks would be when the stock has earnings. An example in commodities is when weather turns really bad or really good. In general, both straddles and strangles are non-directional, but they can be used in directional settings when you want a hedge against price movement in the opposite direction. How do you determine which to use? There are a number of factors here. Straddles are favored when you are willing to lose some, but do not want to lose it all. The max loss occurs only at the single point at the bottom of the straddle, and that is effectively never going to happen. Strangles have a max loss anywhere along the lower floor, and that can happen any time the price doesn’t move very much. Countering this, the straddle costs more than the straddle. Another factor is that the strangle will show a profit faster than a similar straddle, as the price increases or decreases. I will finish off with a few examples. Suppose the cost of crude oil is currently $80 per barrel and there are rumors both of potential sanctions and new discoveries of petroleum fields. It is not clear which factor is going to dominate the price, but it is clear that the price will move significantly. This is a perfect scenario for a straddle. Buying both a call with $80 strike price and a put with $80 strike price, you would be able to capture whichever direction dominates. Another example deals with corn. A while ago, corn was at about 460, and the price was expected to go up from there. You could buy a strangle in this situation to protect the downside. One potential strangle would be to buy a May 2 call at 430 and at the same time sell a May 2 put at 490. You could take profits if May corn hits above break even at 475. IF corn continues its usual pattern of price movement, the only question is if corn will hit 475 by May, and that is quite likely. |