Profit from straddles and strangles

You know the market's going to move, but you don't know which way. That's fine - you can still profit from a 'straddle' or 'strangle' trade, says Tim Bennett. Here, he explains how.

Wouldn't it be great if you could find a strategy that made money from the market no matter which way it moves? Take last weekend's eurozone summit. We all knew it would either be a big disappointment (sending shares much lower) or a surprise success (sending them higher, which it did). But how can you bet on such an outcome?

The good news is, if you're prepared to do a bit of homework, you can, using something called a straddle'. The trade which is built on options is risky, and it's definitely not for novices, but it can work a treat in volatile market conditions.

The basics of options

When you insure your car for the year, you pay a one-off, non-refundable premium for the right to call in money from the insurer should you need to. An option is similar (though not identical).

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With a call' option, you pay a one-off premium (say 10p per share) for the right to buy 1,000 of them at a fixed strike' price (say £2.50) before the option expires after, for example, three months. You pay this premium to the selling party, or option writer in effect your broker.

What are you paying for? Well, if the actual share price at the London Stock Exchange goes to £3, for example, you can in theory cash in the option by buying 1,000 shares at the strike of £2.50 and selling them. Your profit is 50p x 1,000 shares, less your premium of 10p per share, or £100. So that's £400.

In practice, having to buy 1,000 shares via the option contract and then sell them is an unnecessary hassle. As the underlying share price rises towards £3, the option's premium will rise too, since an option to buy shares at a fixed £2.50 gets more and more valuable as the underlying share price rises. So an easier route is just to sell the option once the share price hits, say, £3 (the higher the better), cashing in the difference between what you paid, 10p, and what you can sell it for.

Put' options are the opposite of calls'. Instead of giving you the right to buy 1,000 shares at a pre-agreed strike price, you get the right to sell instead. So if the share price falls, the option's value rises.

What are the risks? Well, if the underlying share price crashes (or surges in the case of a put option) you will never want to exercise your right to buy (or sell) at £2.50, and after three months the option will expire. At that point you've said goodbye to your premium of 10p per share, or £100. In effect, you have lost 100% of your initial investment, which shows just how risky options can be.

Straddling the market

Imagine you could buy a call and a put on the share mentioned above with a strike price in both cases of £2.50. In practice, the premium you pay for the call and the put would be different (the market will have a view on whether the price is more likely to rise or fall, boosting either the cost of calls or puts).

But let's say for this example it's 10p per share or £100. So in total you have paid two premia (£200) for two options. What's the point of that? Say you are positive that a forthcoming company announcement will move the share price you are just not sure which way.

A good example could be pending news of a key drug trial from a biotech company either it passes and the share rockets, or it fails, and the share collapses. By buying a put and a call, you are covered no matter what happens, as long as the share price moves a decent distance.

Say the news sends the price up to £3.50 per share. Now the call option premium will rocket too (the implied profit is around £1 per share, or £1,000, less the £100 premium, so £900). So you can cash in a profit from selling the call option, even allowing for the fact you also need to recover the premium of £100 on your now worthless put option.

Equally, should the underlying share price drop steeply, to £1.50, you get the same implied profit of £1 per share x 1,000 shares the difference between the fixed strike price and the share price now less the £100 premium on the put and another £100 premium on your now useless call. What's not to like about that?

The big risk

The main problem with a straddle is that you sink a lot of money into it £200 in the above example. So you need the underlying share price to move a decent distance before you break even. The actual prices you need the underlying share to hit are the strike price of £2.50 plus or minus two lots of premium of 10p per share. So you either need the underlying share to rise to £2.70 (£2.50 plus 20p) or fall to £2.30 (£2.50-20p) just to stand still. Beyond either of those break-even points, you make a profit.

If the share price doesn't move as you expect, then you are down two premiums, or £200. And remember, that's 100% of your initial investment. One way to cut the cost is to choose a call and a put with different strike dates. This pushes the break-even points out a little further, but usually results in a cheaper overall premium. The trade is known as a 'strangle'.

How it can all go wrong

Sitting on the other side of your position is an option writer. Whereas you have bought two options, they have sold them and banked two premiums up front. The upside is this big income receipt. But the downside can be huge if the market suddenly becomes volatile.

That's what it did for Nick Leeson of Barings. In the early 1990s he began selling straddles and strangles on the Nikkei 225 in effect a bet that the Japanese market would not move much. Worse, he was doing it naked'. When the Kobe earthquake hit in 1994, the Nikkei fell around 1,000 points and the Singapore exchange demanded cash (a margin call) from Leeson to continue with his trades. He came up with it by writing yet more straddles and strangles (now for much higher premiums due to the heightened volatility). When the aftershocks from the first earthquake struck, the Nikkei fell another 1,000 points and he was sunk.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.