Straddles and Strangles - Two Positions for Specific Market Bias

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When traders and investors consider a specific investment, they must decide their price bias in terms of the asset they are contemplating. This will give rise to a selection of an appropriate market vehicle to employ to go long or short. In the world of commodities, there are many choices of vehicles including, futures, options on futures, commodity equities or ETF and ETN products. It is an easy process when one has a clear view that the price of an asset will either appreciate or depreciate.

However, after doing the requisite research the conclusion may not be so clear. Many times market participants will conclude that the price of an asset will move however, they are not sure in which direction. Other times the conclusion is that the price of an asset will not move much, rather it will continue to consolidate in a narrow range. In these two situations, there are market tools that allow traders and investors to express these opinions where traditional long and short positions are not appropriate.

Price direction versus volatility

When someone is bullish or bearish on the price of a commodity they can simply go long or short a number of different available vehicles to express that view. This is a clear directional bet. When they believe that the market will experience a large move but they are not sure if that move will take prices higher or lower or, if they think the market will trade in a narrow range there are certain products available.

In these cases, traders or investors can trade volatility rather than price direction.

Two option strategies are perfectly suited for those market participants who wish to take a position in volatility rather than one for a move in a specific direction. The key determinate of option prices is implied volatility.

Thus an option straddle or strangle position in a market will result in a volatility rather than a unidirectional position.

Straddles

A straddle is an option position where a put and call with the same strike price and same expiration date is combined. The buyer of the straddle pays the premium for the option position and the seller of the straddle collects the premium. An example of a straddle in gold futures would be as follows:

Current gold price = $1200

December 1200 call option = Premium of $30

December 1200 put option = Premium of $30

Total December 1200 straddle premium = $60

A trader or investor who expects a big move in gold without having an opinion on the direction of the move would likely be a buyer of the straddle. If they are correct and there is a big move in one direction or the other they will make money so long as the price of gold moves above $1260 or below $1140 by expiration of the straddle. Conversely, a trader or investor who believes that gold will trade in a narrow range would likely sell the straddle  -- if the market remains between $1140 and $1260 until the straddle expires they will make money. Therefore, straddles can be the perfect tool for those who think a market will move and those who do not.

Strangles

A strangle is an option position where an out of the money put option and an out of the money call option for the same expiration date is combined. The buyer of the strangle pays the premium for the option position and the seller of the strangle collects the premium. An example of a strangle in gold futures would be as follows:

Current gold price = $1200

December 1300 call option = Premium of $8

December 1100 put option = Premium of $8

Total December 1100/1300 strangle premium = $16

A trader or investor who expects a big move in gold without having an opinion on the direction of the move would likely be a buyer of the strangle. If they are correct and there is a big move in one direction or another they will make money so long as the price of gold moves above $1316 or below $1084 by expiration of the straddle.

Conversely, a trader or investor who believes that gold will trade in a narrow range would likely sell the strangle  -- if the market remains between $1084 and $1316 until the strangle expires they will make money. Strangles can be the perfect tool for those who think a market will move big time and those who do not.

The bottom line

If you think the price of an asset will move higher or lower you can always take the appropriate long or short position to express your view. However, if you believe that a market will move in a big way and you are not sure of the direction, or if you think a market will trade in a range straddles and strangles may be the perfect tools to express that opinion and make some money.