The Strangle And The Straddle Strategies

In order to hedge or reduce risk, pay a lower premium or increase their chances for profit, forex traders, like stock traders, may combine a number of options contracts. Those different combinations of currency options constitute in fact options trading strategies. Among the most common are: the strangle and the straddle strategies. Both option combinations are available directly on the Finotec online trading platform.

The straddle strategy:

Investors use this option trading strategy when they expect a sharp swing in the exchange rate but don’t know if it’s going to go up or down. This happens during highly volatile market conditions. In this case, they use a buying straddle strategy. On the other side of the transaction, sellers use this forex option strategy in a stable market, when they expect neither sharp rise nor sharp fall in the exchange rate. In this case, they use a selling straddle strategy.

This is one of the most popular forex options trading strategies and it consists in buying (in the case of a volatile market) or selling (in the case of a stable market) both a call and a put option at the same strike price and for the same maturation date. The value of a straddle option (the premium or price of the option paid at spot value) increases along with the volatility and the maturity of the underlying currency pair.

Long straddle strategy

Short straddle strategy

Possible outcomes of a straddle strategy:

For the buyer (long straddle)

If, after buying a call and a put option at a same strike price, the market remains stable and the volatility remains at low levels, the buyer loses the two premiums he paid for each option.

If the market rises far above the strike price, above the rate where the buyer starts making profit (the break-even rate), the buyer will exercise his right to the call option he purchased and buy the underlying currency at the strike rate. The sharper the rise, the greater the chance of making profit. If there is a sharp rise in the exchange rate, the buyer will make some profit as long as this profit is higher than the two premiums he paid in advance.

If the market falls well below the strike price, below the break-even rate (the point where his profit is greater than the two premiums he paid in advance), the buyer will exercise his right to the put option and sell the currency at the strike price. The sharper the decline of the currency, the greater the chance of making profit.

If the buyer purchased his options at a time of low volatility and volatility rises, he could profit from both options even with small market moves.

For the seller (short straddle)

If there is little or no change in the spot rate, the options contracts will expire worthless and the seller will keep both premiums (this represents the maximum profit). The seller will still profit if the exchange rate remains below the strike price – as long as it is above the lower break-even rate. The seller will also profit if the spot rate remains above the strike price – as long as it is below the upper break-even rate. In any case, the writer of the straddle will benefit if the spot rate remains very close to the strike rate.

The seller will incur losses if the there is a sudden swing in either direction. There is no limit to the losses he/she might incur.

The strangle strategy:

This is also one of the most popular options trading strategies. It consists in buying or selling a call and a put option at different strike prices. Like the straddle buying strategy, traders use the strangle buying strategy when they expect a sharp swing of the exchange rate in either direction. The buyer will purchase an out-of-the-money call option contract as well as an out-of-the-money put option contract. The strangle buying strategy has unlimited profit potential if the exchange rate moves enough in either direction. The value of a strangle option increases along with the volatility of the underlying currency.

Long strangle strategy

Short strangle strategy

On the buyer’s side:

Using this strategy, a trader (buyer) can benefit from a sudden movement of the exchange rate regardless of the direction. The potential profit is unlimited and the potential loss is limited to the two premiums. If the exchange rate expires between the two strike prices, the buyer will sustain a maximum loss (the value of both options). For the buyer to make a clean profit, the spot rate at the expiration date will have to either be above the upper break-even rate or below the lower break even.

On the seller’s side:

If the exchange rate remains between both strike prices at expiration, both the put and the call options will expire worthless and the seller will keep the value of both premiums (maximum profit). The seller will make some profit even if the spot rate is below the put strike, as long as it is above the lower break even rate. The same way, he/she will still profit to some extent if the spot rate is above the call strike price, as long as it is below the upper break-even point. Also, since the seller uses two different strike prices, the spot rate enjoys a wider moving range than in the short straddle strategy to be profitable.