Something big is about to affect your portfolio. The Food and Drug Administration is reviewing your biotech stock’s latest product, and you’re not sure whether it’ll get approved. Or, maybe a disruptive election outcome looms, and the race is tighter than expected.
In either case, you don’t know whether the result will be good or bad for your holdings. What do you do? If you’re options-licensed, consider a straddle or a strangle.
While they might evoke images of the Wild West, these names were designed to allow investors to both protect downside and capture upside using puts and calls. They can be used on stocks, bonds, indexes, currencies and commodities—any securities for which options contracts can be written.
Investors use straddles and strangles “to take a position on volatility,” says Matthew Cardillo, vice-president, investment management at Mackenzie Investments.
And often that position is a hedge against volatility going the opposite way from what you’d expect. “Most investors don’t use options to speculate, especially if you’re managing a fund or a large amount of money,” says Devin Ekberg, managing director of education at the Investment Management Consultants Association. “They’re using options more as complements to the underlying investments.”
For instance, investors may use straddles and strangles to protect downside as they figure out what to do with a holding, while not completely forgoing upside. “Let’s say, instead of selling it and triggering a tax event, or a turnover in my portfolio, I’m going to use options via a straddle or strangle to make the bet instead,” says Ekberg.
But that flexibility comes at a cost, since you must purchase both a put and a call to execute the strategy. As a result, it often takes an extraordinary event to make these strategies profitable, cautions Cardillo, who’s one of three portfolio managers using derivatives at his firm. That’s because options markets are usually good at pricing in volatility—if you know a big event’s coming, everyone else probably does, too.
Nonetheless, extraordinary events happen.
One such event was Amazon’s June announcement that it was buying Whole Foods Market. Within a half-hour of the subsequent market open, US$29 billion in market capitalization had disappeared from Whole Foods’ grocery rivals, including Target, Costco and Wal-Mart.
If you’d been prescient enough to enact a straddle or strangle on Target at close of business two days previous, you’d have seen triple-digit returns: 280% for a straddle and 592% for a strangle (see “Real-life examples”). The returns were made buying options on Target, as opposed to Target’s shares.
Such outsized returns are unusual, but they illustrate the strategies’ power, and that recording losses of the same size could be just as easy if you went short. While straddles and strangles are meant for knowledgeable traders, it’s helpful to understand the principles. In this article, we’ll look at how they work, when they’re appropriate and their risks.
Investors use straddles when they anticipate a volatile event will affect an underlying security, and they don’t know whether the impact will be good or bad. Such events could be security-specific (e.g., an uncertain earnings report; an anticipated regulatory approval or disapproval) or macro (e.g., Brexit or an election).
In a June 2017 note, Goldman Sachs’ derivatives team suggested implementing straddles during the weeks leading up to earnings reports, when companies make pre-announcements. The straddle would allow investors to profit on big moves, regardless of whether the pre-announcements were positive or negative.
Cardillo gives an example of when a straddle could work for bonds. “If you think the Trump administration is not going to raise the debt ceiling, there could be a lot of consternation and angst in the Treasury market,” raising volatility, he says. “If that event wasn’t anticipated, you could make money on a straddle. Even though Treasurys aren’t a very volatile instrument, what matters is the increase in volatility.”
How it works
- Buy an at-the-money call option (e.g., if the stock price is $50, the strike price is also $50). The call’s value would increase if the stock price went up, since you could purchase the stock at $50 instead of at the higher price.
- Buy an at-the-money put option (e.g., if the stock price is $50, the strike price is also $50) with the same expiration date as the call option. The put’s value would increase if stock price went down, since you could sell the stock at $50 instead of at the lower price.
This strategy costs money to implement—namely, the cost to purchase both the put and the call. As such, investors often use straddles when they have a specific event in mind, over a specific timeframe.
That cost also prevents investors from buying straddles on anticipated events far into the future—such as the 2020 U.S. election. “You still have to deal with that position between now and then,” says Ekberg. Not only would investors have to tie up capital for three years, but the options’ value would decay over the period.
As the Options Industry Council puts it, “The passage of time erodes the position’s value a little bit every day, often at an accelerating rate. [Meanwhile], the hoped-for volatility increase might come at any moment or might never occur at all.”
And even if volatility occurs, it may not be enough.
First, options are usually more expensive when volatility is expected. And as Ekberg explains, “If the options were priced in such a way that they were expecting the price move, you may not make any money on the trade,” he says. “You’re making this bet that the market hasn’t priced in enough of a move.”
Second, “When you’re buying both upside and downside, the key is the security price has to move far enough to pay for both sides of the bet,” says Ekberg.
If possible, experts recommend analyzing how a security has responded to similar past events to see if the straddle’s cost is worth it. Investors should also get an idea of recent historical volatility in the stock, and whether, say, a biotech or health stock is awaiting FDA approval on a new product that could make or break the company.
With straddles, the maximum loss is the premiums paid. That will happen if the security doesn’t move at all from the strike price (in our example, the stock would stay at $50), and both options expire worthless.
Meanwhile, the maximum upside is unlimited, since the stock could theoretically rise to infinity. If that happens, the call would still allow the investor to purchase the stock at $50. (If the stock falls to zero, the max gain is the strike price of $50 less the cost of the straddle).
Table 1 shows what it looked like to execute a straddle on Target stock two days before Amazon announced it was buying Whole Foods on June 16.
Table 1: Return to a straddle on TGT (Target Corp.) that was entered into on June 14, 2017 at 4 p.m.
cost of position
|Cost on June 14 at 4 p.m.||$0.33||$1.39||$1.72|
|Value on June 16 at 10:30 a.m.||$6.50||$0.05||$6.55|
Source: Matthew Cardillo, Mackenzie Investments
Target closed June 16 down 5.14%, having dipped 12% at one point.
Like straddles, investors use strangles when they anticipate a volatile event will affect an underlying security, but don’t know whether the event will be good or bad for the security. Such events could be security-specific or macro.
The difference between straddles and strangles is that strangles “widen out the number of outcomes that can happen,” says Ekberg.
How it works
- Buy an out-of-the-money call option (e.g., if the stock price is $50, go for a higher strike price—say $55). The call’s value would increase if the stock price went above the strike price, since the owner would be able to purchase the stock at $55 at expiration instead of at the higher price.
- Buy an out-of-the-money put option (e.g., if the stock price is $50, the strike price is lower—$45) with the same expiration date as the call option. Usually the call and the put are roughly equidistant from the current price (e.g., plus/minus $10). The put’s value would increase if stock price went below the strike price, since you could sell the stock at $45 at expiration instead of at the lower price.
The pitfalls are the same for straddles and strangles, except for two elements:
- Since out-of-the-money options are less expensive than at-the-money options, a strangle is generally less expensive than a comparable straddle.
- The wider range for strangles means that “a larger move in the underlying [security] is generally required to reach breakeven,” says the Options Industry Council website.
Table 2 shows what a strangle execution looked like on Target stock two days before Amazon announced it was buying Whole Foods on June 16.
Table 2: Return to a strangle on TGT (Target Corp.) that was entered into on June 14, 2017 at 4 p.m.
cost of position
|Cost on June 14 at 4 p.m.||$0.08||$0.65||$0.73|
|Value on June 16 at 10:30 a.m.||$5.03||$0.02||$5.05|
Source: Matthew Cardillo, Mackenzie Investments
Shorting straddles and strangles
Investors short straddles and strangles if they think a security will stay at its current price (straddle) or within a range (strangle); in other words, they don’t anticipate a major price move in either direction, nor do they anticipate volatility.
How it works
If you already own the underlying security, the strategy is technically a covered strangle or straddle.
- Sell an at-the-money call option (e.g., if the stock price is $50, the strike price is also $50) and collect the premium. If the stock price is up at expiry and you own the stock, you’ll still have to sell it at $50, creating opportunity cost. If you don’t own the stock, you’ll have to buy it on the open market at that higher price, but can only sell it for $50.
- Sell an at-the-money put option (e.g., if the stock price is $50, the strike price is also $50) with the same expiration date as the call option, and collect the premium. If the share price is down at expiry, you’ll still have to buy it at $50, creating opportunity cost.
- Sell an out-of-the-money call option (e.g., if the stock price is $50, the strike price is higher—say $55) and collect the premium. If the stock price is above the strike price at expiry and you own the stock, you’ll still have to sell it for $55, creating opportunity cost. If you don’t own the stock, you’ll have to buy it on the open market at that higher price, but can only sell it for $55.
- Sell an out-of-the-money put option (e.g., if the stock price is $50, the strike price is lower—$45) with the same expiration date as the call option, and collect the premium. If the share price is below the strike price at expiry, you’ll still have to buy the stock for $45, creating opportunity cost.
Shorting straddles and strangles is an income strategy, but one with limited upside. Your maximum profit comes if the stock price stays the same (straddle) or within the range (strangle). In that best-case scenario, the options will expire and you’ll collect the entire premium on the puts and calls. If you own the stock, your upside would be any capital gain (when you eventually sell) plus the premiums collected. If you don’t own the stock, your maximum profit is equal to the premiums collected.
The downside, however, is substantial. If you own the stock, the worst-case scenario is the share price falls to zero at expiry. Then, not only is the stock you own worthless, but the put owner will exercise her option to have you buy her stock at the strike price. If you don’t own the stock, the worst-case scenario is that the stock rises to infinity. Then, potential losses are unlimited since you must buy the stock on the open market at the infinite price and sell it at the much-lower strike price.
In both cases, losses would be offset by the premium income.
Ekberg uses a hypothetical example of owning Apple stock.
If you sell a covered strangle against Apple, he says, “you’re making a bet that Apple will stay within the range of the strangle you just created.” By selling an out-of-the-money call option, you collect a premium and obligate yourself to sell Apple if it reaches that strike price at expiration. “But you’re saying you have your doubts that Apple will reach that price,” he points out, and therefore you don’t think you’ll have to sell Apple stock.
By selling an out-of-the-money put, “you’re collecting a premium and obligating yourself to buy more Apple stock if the price drops that far,” says Ekberg. “And I would be OK with the outcome if I had to, but I don’t think I’ll have to.”
For long straddles and strangles at purchase, the Greeks are as follows:
Delta—neutral at 0 (the at-the-money put and call have deltas of -50 and 50, respectively, which add up to zero)
Gamma—positive; highest at the strike price
Theta—high (“When you buy an option, you have time working against you,” says Ekberg. “When you buy two options, you have time working twice against you.”)
Vega—very positive (due to anticipated increased volatility)
The opposite applies for short straddles and strangles.
Strength of straddles
“Goldman Sachs […] looked at more than 25,000 corporate earnings reports since 1996 and found that investors who bought straddles five days before earnings and closed the trades one day after made an average profit of 24% with a success rate of 56%,” reports Business Insider. “They ran a similar analysis more broadly for all stocks and saw an average profit of just 2% with a success rate of only 35%.”
When the bid-ask spread matters
When making an options trade, don’t forget about the bid-ask spread—the gap between the asking price and the bidding price. The bigger the spread, the lower your potential premium.
Doug Waterson, CFO and portfolio manager with Faircourt Asset Management in Toronto, says he writes out-of-the-money call and put options, with timeframes of fewer than 30 days, on his portfolio’s stocks, particularly volatile gold names.
For names he’s exiting, Waterson writes covered calls with strike prices above the market price of the underlying stock. Conversely, for stocks he’d like to own, he uses cash-secured puts with strike prices below the market price.
The cash-secured puts, for instance, are a way to purchase companies he wants for the portfolio when he sees price weaknesses. If the stock hits the strike price, the put holder will exercise the put. Either way, Waterson gets the premium.
But Waterson says it’s often difficult to find attractive bid-ask spreads in Canada, where the options market has less trading and fewer brokers.
“The size of the U.S. market dwarfs us,” he says, noting he usually prefers to write his options on U.S.-listed or interlisted names that offer more attractive spreads. “If I’m selling the option, somebody is buying it and, typically in the U.S., that [trading] is so liquid that the spreads will come down.”
It’s common to see “penny spreads” for actively traded options in the U.S, he says. In Canada, that’s rare, where the spreads can be “unconscionably wide.”
How does Waterson find the best spread? When he sees an option-writing opportunity, he contacts a handful of dealers on a messaging platform—identifying the trade, the number of contracts and the price. The requests are immediate. If there’s a deal offering a suitable spread, the order must be filled right away. From there, time is his friend. –Simon Doyle