By the end of this article you will know the pros and cons of trading straddles versus strangles.
Structures are the tools option sellers use.
Lets start with an analogy to understand why different structures exist to begin with. Let’s say you were running a business as an electrician and you landed a job working on someones house. When it’s time to work do you just show up empty handed? Or do you, depending on the job to be done, bring the tools needed with you?
In the world of options we have tools that we use too in order to “get jobs done”.
For example, if we think that implied volatility will be higher than realized volatility over the next 30 days, there are specific option structures (tools) that we can use in order to express this opinion on the market.
In this section we are going to discuss the primary trades that we will be placing and the pros/cons of each.
The option structures we will be covering are Straddles, Strangles, and iron flys.
Straddles are the most common way that professional traders go about selling volatility. The reason is simple: the range of movements covered by the straddle are basically the implied range of movement by the market between now and expiration. It basically is the implied volatility.
This is what a straddle looks like:
You create this structure by selling a call and a put at the same strike. In this case, the strike you pick the the at-the-money strike, which is the one closest to the current underlying stock price.
Pros: You collect the highest premium and at the money strikes tend to have the most liquidity.
Cons: the maximum profit is made only if the stock price stays right at the same price as your strikes. Your delta exposures change regularly and with every small movement in the stock.
This is what a strangle looks like:
You structure this by selling an out of the money call and an out of the money put , equal distances away from the current stock price. For example, if the current stock price is $100, you might sell a 95 strike put and a 105 strike call. For example, you will often see traders doing a delta 30 to delta 40 strangle (the delta of calls/puts traded).
Pros: You have wider break evens so there is greater allowance for movement in the underlying stock which still results in a positive gain for you. It also can help reduce the frequency at which you need to delta hedge your position which can save you time and trading costs.
Cons: You collect less premium and the losses incurred by outsized moves are greater.
Choosing between straddles and strangles.
Whether you choose to trade a straddle or a strangle does not really impact your long term expected value in theory. All else held equal, your EV should be the same.
The straddle has a higher max gain, with slightly less losses, but it has a lower probability of profit. The strangle has a lower max gain, slightly higher losses but a higher probability of profit. It all nets out.
Where the big differences come in have to do with your view on delta hedging, the frequency with which you are comfortable doing it the cost for you to do it. The strangle, even though you may leave some money on the table in the short term, is more flexible for traders looking to spend less time managing their trades.
Whenever you are selling volatility your structure is fundamentally either a straddle or a strangle, if you trade an “iron fly” or “iron condor”, the body of it is still a straddle/strangle, but you are giving back some of your premium to limit your losses.
This is what an iron fly looks like:
If you focus on the center of it, it looks the exact same as a short straddle, right? Thats because the core of this trade is selling the at the money straddle. That is what gives it the overall short volatility profile (the thing that we want).
The reason the max loss is limited (indicated by the blue lines going horizontal on both sides at a certain loss) is because you actually purchase an out-the-money strangle as a way to hedge your risk. This is called “buying wings” which is why the term is iron fly/butterfly. Basically, after a certain size move, you have deep out of the money options that start to become profitable and neutralize and further damage from stock movement.
Should you buy wings?
Do I think you should buy wings? My personal opinion is no. I do not think you should be buying wings because the reason we are getting paid is for holding the risk that there is a large move in the underlying stock. If you buy the wings, you are reducing this risk, and in turn, reducing your overall risk premium. There is not a massive risk premium on average to start with, so you risk turning a +EV trade into a -EV trade. If you do choose to buy wings, make sure to buy them far out of the money. They are “disaster insurance” if anything at all, so make sure they are acting as such.
If you choose to purchase the wings, that is OK but you need to understand that you are making a trade off.
Pros: you now have a maximum risk and will not suffer major losses if the stock experiences massive moves compared to what was implied. Buying wings reduces the impact on your buying power usage to whatever the max loss on your trade is.
Cons: You are giving up some of the premium you collected and may no longer be taking a long term positive expected value trade.
Ranking the structures used by option sellers:
So overall my current preferences are, in order:
#1 Strangles.
#2 Straddles.
#3 Iron Flys.
Remember though that in the end of the day these are just the tools that we use to do our jobs that we find (run our option selling business). And remember, no electrician makes money “because hammer”. It’s because they know what jobs they can do that pay the most.
So your entire focus should really be on finding good trades. Understand the tools, when to use them and then implement them in the appropriate spot.
