Strategies to Profit From Volatility

By Scott Chan, Investing Daily, Saturday, February 20

For beginners to options trading, there are so many different strategies available that things can get confusing. This is especially true when two strategies work similarly and even sound similar.

Today, let’s take a look at the difference between a straddle and a strangle.

A straddle is when you buy to open a call and a put on the same stock at the same time. Not only is the stock the same, but the strike price and the expiration date are the same.

A strangle also involves buying to open a call and a put on the same stock at the same time. However, the difference is here the call and the put will have different strike prices.

Both strategies are a bet on volatility. They are useful when you think a stock will make a big move but you aren’t sure which way it will go. For example, a highly-anticipated earnings report is coming up or a drug company’s PDUFA date (when the FDA is due to make a decision on a drug candidate) is approaching. If the stock does make a big enough move, you will profit whether the stock rallied or dropped.

You Want a Big Price Movement

Let’s use a real-world stock as an example. Athenex (NSDQ: ATNX) expects to get an FDA decision (PDUFA date, February 28) on oral paclitaxel, a treatment for breast cancer. If approved, patients would be able to take a pill at home rather than receive paclitaxel by IV infusion.

Experts think oral paclitaxel could have peak sales of $1 billion or more. For a small company like Athenex, the fate of the drug is obviously a very big deal. Thus, there’s a good chance that depending on how the FDA decision goes, the stock could make a big move, either up or down. You think no matter how the decision goes, the stock will react by sharply jumping or sharply falling.

As of this writing, the stock trades at about $13. Let’s say you want to do a close-to-the-money straddle right after the FDA decision. The closest strike and expiration date you can find is the March 12.50 calls and puts expiring on March 19. You simultaneously buy the call for $300 ($3.00 x 100) and the put for $175 ($1.75 x 100), for a total of $475. (These are actual real-world prices as of this writing.)

If you were doing a strangle, you could buy the March 15 call and the March 12.50 put. Your cost would be $220 ($2.20 x 100) for the call and $175 ($1.75 x 100) for the put, for a total of $395.

How It Could Play Out for the Straddle

The chart below shows what your gain or loss would be if you held both legs of the trades to expiration.

For the straddle, the worst thing that can happen is ATNX ends up exactly at $12.50. In this scenario both the call and put would expire worthless and you lose the premiums you paid, $475.

If ATNX ends up above $12.50, then the put expires worthless but the call is in the money. And if the stock is below $12.50, then the call expires worthless but the put is in the money. The breakeven points for you would be $7.75 and $17.25.

This means that if ATNX is lower than $7.75 or higher than $17.25, then the straddle would end up profitable because the leg that’s in the money will be deep enough in the money to cover your premium cost. If the stock is between $7.75 and $17.25, then your trade will be unprofitable overall.

And the Strangle

For the strangle, your worst-case scenario occurs when the stock ends up between $12.50 and $15. In this case both the call and the put expires worthless and your loss is the premium you paid, $395.

Your breakeven points are $8.55 and $18.95. If ATNX ends up lower than $8.55 or higher than $18.95, then the put or the call will be deep enough in the money to cover the cost of the premiums and you will profit on the trade.

The key differences between the two strategies are: 1) it is cheaper to do a strangle, but 2) there is a greater maximum-loss range in a strangle.

You will also notice that you need quite a large change in the stock price to make money because the premiums are high. This is because the option sellers also anticipate volatility around the PDUFA date and want a higher premium to compensate for the risk. Also note that the stock cannot fall below zero, so there’s a limit to how much you can profit on the put, but there’s no limit to how high the stock could go, so there’s greater profit potential on the call side.

To be clear, the Athenex example is merely an example to illustrate how a straddle and strangle would work. It’s not a recommendation. Also, in real life, you could always close out one or both legs of the trade prior to expiration so your return could be vastly different than shown on the charts.

In this article what we talked about is actually a long straddle and long strangle. It’s possible to do a short straddle and short strangle as well. That’s something we will discuss at a different time.

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