What is it ?
- Long straddle=long a call and long a put with the same strike price.
- Long strangle =long a call and long a put with different strike price.
How is it constructed ?
- Trade can be executed as a simple options trade. An investor would go long a straddle / strangle in the hope that the underlying will move a long way from strike.
- A long straddle can be delta-hedged regularly, if investor expects high volatility around the strike (where there is most gamma). Such delta hedging locks in gains.
What is the payoff ?
Max profit : Unlimited
Max Loss : Limited to option cost
When is it used ?
Straddle (with no delta hedge):
- Investors will go long when expect the underlying to move significantly, but are unsure as to which direction. The position would also profit from a rise in implied volatility.
- Short when one expects an underlying to finish at a certain price.
Strangle (with no delta hedge):
- Investors will go long a strangle when they want to enter the position at a reduced cost, and they expect the underlying price to move very significantly.
- Investors will go short a strangle when they believe that implieds are overpriced, and they expect an underlying to remain range-bound. Shorting a strangle can be regarded as less risky than sorting a straddle.
With delta hedge :
- Both straddles and strangles can be used with delta hedging when an investor expects high volatility around the strike price (where gamma and returns from delta-hedging will be greatest).
What are the benefits ?
- Simplest way of taking a view on volatility.
- Loss limited to cost of the options while gain is potentially unlimited.
- Strangles are less risky to write, and cheaper to buy than straddles (as both call and put are out of money), although returns are lower.
- Both can be used in conjunction with delta hedging to take a view on realized volatility. Spreads will be smaller than on variance swaps, but the position will need daily management, and will need to be re struck if spot moves away from the strike of the options ( since there is much less gamma at the wings. )