In options trading, volatility is the rate at which the price of a financial instrument fluctuates over a particular period. Every trader will encounter volatile markets on their trading journey, where prices become unpredictable. To mitigate this, professional traders came up with two volatility strategies: the straddle and the strangle.

This article will discuss the two volatility strategies in options trading, such as what they are, how traders can spot them, and the ways in which they can be used. If you are interested in learning more about options trading and the type of options available in Hong Kong, you can get started with a reputable broker such as Saxo.

The straddle in options trading

The first volatility strategy we will explore is the straddle. To put it simply, the straddle involves buying at-the-money strike puts and strike calls with the same expiration date. The number of puts and calls must be equal, so you are creating a net debit transaction.

The unique part about the straddle is that it has two breakeven points: one below the strike price, and one above. As you set the same strike price for both purchases, you have opportunities to break even on both the downside and the upside.

How to find an opportunity to trade the straddle

To trade the straddle, you should look out for the following:

• Low implied volatility compared to the average implied volatility over the medium term (a few months to a year)
• Implied volatility is lower than historical volatility over the short term (within the past one to three months)
• Declining implied volatility – this is seen visually by way of individual price bar lengths getting shorter over time
• A stock that has room for substantial upward or downward movement – in other words, a volatile stock

How to trade the straddle

Using the straddle strategy to trade can be broken down into four simple steps.

First, you should identify the stock you want to trade, and you should determine if it has any potential for explosive price movements in either direction. A good way to detect this is to see if there will be any news on the company that issues the stock, such as quarterly or annual earnings reports being announced or a change of management teams.

The key is to place your trades before the announcements are made, so you can capitalize on the price movements that manifest immediately afterward.

Then, you should purchase the options contract with just enough time so that you will not have to pay substantial premiums. In the ideal scenario, you will trade straddles three months in advance, so you have sufficient time to exit your position regardless of your speculations.

When the announcement has been made, if there are no price movements and the stock price seems relatively stable, you should exit the trade quickly to minimize your risk exposure. However, if there are indeed substantial price movements, you can define your own strategy based on your trading objectives and exit your position accordingly.

If there is volatility in the market, you may also choose to exit the profitable position while holding onto the unprofitable side in case of sudden price retracements. Alternatively, you can choose to do the opposite. You can exit the unprofitable position but hold onto your profitable position to continue benefiting from the price surge in that direction until the trend breaks.

An important tip for trading the straddle

A very important thing to remember when trading the straddle is never to leave an open option position on either side with less than one month to the contract’s expiration date. This is due to time decay, which is the biggest risk a trader takes when they trade the straddle.

Time decay happens most rapidly in the month leading up to the expiration date. This greatly endangers your investment.

Advantage of the straddle

The straddle is not a high-risk strategy, for one. When executed correctly, the maximum risk is the net debit of the spread when you purchase your strike puts and strike calls, while the maximum reward you may reap is unlimited.

Drawback of the straddle

The straddle can be an expensive strategy, and traders will need a greater amount of cash to be able to buy both strike puts and strike calls.

The strangle in options trading

The strangle is the second volatility strategy traders can employ. It involves buying on-the-money strike puts and strike calls with the same expiration date. Like the straddle, the number of puts and calls must be equal, so you are creating a net debit transaction.

The strangle also has two breakeven points: one below the strike price, and one above. Unlike the straddle, the put strike price and call strike price are different when employing the strangle technique. This is because the put strike price is set below the current asset price, while the call strike price is set above it.

How to find an opportunity to trade the strangle

To trade the long strangle, which is one of two options of strangle strategies, you should look out for the following:

• High implied volatility compared to the average implied volatility over the medium term (a few months to a year)
• Implied volatility is higher than historical volatility over the short term (within the past one to three months)
• A stock that has room for substantial upward or downward movement – in other words, a volatile stock

How to trade the strangle

Using the strangle strategy to trade can be broken down into four simple steps.

First, choose the stock you want to trade based on any implied volatility in the future three months. Make your purchases well ahead of time.  This is so that you can avoid the risk that comes with options contracts’ time decay.

If the realized volatility is that there are no price movements after a major announcement you were anticipating, and the stock price remains relatively stable, you should exit the trade quickly to minimize your risk exposure. However, if there are indeed substantial price movements, you can define your own strategy based on your trading objectives and exit your position accordingly.

Advantages of the strangle

The strangle is slightly cheaper than the straddle, as it requires buying on-the-money options. There are also two ways for you to trade strangles – the short strangle or the long strangle. This means traders will have the opportunity to profit on potential upward and downward price movements.

Disadvantages of the strangle

The strangle, like the straddle, requires volatility in the markets in order to be effective. This means they are not suitable for trading in relatively stable financial markets. Another disadvantage it shares with the straddle is the potential effects of time decay of options contracts. This can really eat into any potential gains made.

The bottom line

Volatile markets can potentially be rewarding when traded with caution. However, before using any options trading strategies, you should ensure that you know enough about options and the options market. These strategies are more complex than most, and there is always the risk of loss in financial markets. Therefore, you should aim to have a good understanding of them. Traders should also never invest more money than they can afford to lose.

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