Written Straddle or Strangle

Market view

To write a Straddle or a Strangle is a suitable strategy when you believe in a relatively neutral market with small movements.

 

Construction

You establish the Straddle or Strangle strategies by writing both call and put options with the same maturity month and the same, (Straddle), or different, (Straddle), strike prices. The advantage compared with establishing a neutral time spread is that you sell even more volatility and time value and you receive a capital income. On the other hand, your risk of loss will be unlimited and therefore larger margin requirements will apply.


Example:
It is the 12th of December. After heavy market declines in September and October the ABC-index has, after a following fast rise, been traded in the interval 630-660, and now the value is 650. The heavy movements have caused historically high option prices, (high implied value). Since you believe in a calmer market until New Year when the options valuation will move towards its historical mean value, you decide to try to profit from the high options valuation and write a Straddle with expiration on the forth Friday in December.

Since the market is still relatively worried and therefore the risk for new heavy movements is large, you want to have large margins. You choose to write 10 call option contracts at a strike price of 720 at an income of 750 per contract and at the same time write 10 put option contracts with a strike price of 580 at an income of 800 per contract. Your total premium received is therefore (10 x 750) + (10 x 800) = 15,500.

 

Results on the expiration day

The outcome from the different index levels on the expiry day is shown in the table below:

 

Profit, loss and break-even

The maximum profit from the above position amounts to 15,500.
That arises at an index closing level between 580 and 720, corresponding to a rise or decline of slightly more than 10 percent. The maximum profit from a written Straddle or Strangle is always the received premium. At an index level below 580 or above 720 your profit will start to decrease and at levels below 564.50 or above 735.50, corresponding to index movement of slightly over 13 percent, it will turn into a loss.

The maximum loss is in theory unlimited since the index level does not have any upper boundry. At dropping levels the risk of loss is only limited by the fact that the index level never can fall below zero.
 

Realization of profit

If you write a Straddle or a Strangle you will, even with a correct market opinion, never be able to realize the maximum profit until expiration. This is due to the fact that the point of writing both call and put options at the same time is to sell a maximum amount of time value, and the time value will not be zero until the options expire. The value of your written options will however decrease fast if you are correct in your belief of falling volatility. The determination of when you should realize a hypothetical profit will be based on an individual balance between how much more you can profit from holding the position until expiration and the unlimited risk at a heavy index movement during the remaining time to maturity. You also have to consider the alternative return you can achieve if you close the position before expiration and therefore release capital that otherwise would have been used for margin requirements. Generally within the options literature, it is considered appropriate to close this kind of position at the latest when 75-90 percent of the maximum profit can be received.

 

Follow up and protection

Since the theoretical risk of loss in a written Straddle or Strangle is unlimited, very careful surveillance is needed. If you notice that the index value, contrary to your market opinion, for example starts to rise substantially, you have several different possibilities to reduce a loss, for example: 

1. Buy back your written call options at the latest when the cost is equal to the total amount received from your written Strangle and keep the call options written naked, (high risk).
    
2. If you believe that the market will continue to rise, but not very far, you can of course also move up the Strangle by buying back the written options at a strike price of 580 and 720 and instead write at strike prices higher up.
    
3. If you, despite a market rise, do not want to adjust your position, since your opinion is that the market will turn down again, you can with an incorrect analysis buy 10 contracts ABC index futures at 720, at latest, and therefore be fully protected against a continuing market rise. On the other hand, the futures bought will imply that your risk at a falling market will increase.

If instead, the problem is that the index level starts to fall substantially, the above proposals can easily be adjusted so that you instead:
 

1. Buy back the written put options
2. Move down the whole Strangle
3. Sell 10 contracts of index futures / ABC index futures

Advantages with a written Straddle or Strangle 

• Possibility for high returns in still markets.
• Possibility to act on a falling volatility opinion.
• Good possibilities to avoid a loss having had an incorrect market opinion.

Drawbacks with a written Straddle or Strangle 

• Limited profit potential
• Unlimited risk of loss
• Large margin requirements
• Demands very careful surveillance

Choice of strike prices

The strike prices you should choose very much depend on how much you think the market can move and on what possibilities you have to watch the options market. The tighter the interval between the written options is, the larger capital income you will receive. On the other hand, the margin requirements you will face will increase and the probability that the index value will move outside some of your strike prices and increase.

If you, instead of the broad Strangle in the above example had chosen to write both call and put options at a strike price of 650, (Straddle), you would have received an initial income of approximately 60,000. On the other hand your break-even would then have moved inwards and already at an index level of 590 on the downside and 710 on the upside, the profit will to turn into a loss. This corresponds to a value movement of slightly less than five percent. In other words, the higher return you strive for, the more risk you will need to take.