An Alternative Option Strategy for Breakouts

By Larry Benedict, editor, Trading With Larry Benedict

Some readers occasionally ask about an options strategy called a “straddle.” And I understand why…

A straddle is when you simultaneously buy a call and a put option on a stock. The call option enables you to profit from an up move… and the put option helps you profit from any fall.

Both options have the same strike price and expiration date. You also use at-the-money (ATM) options. That’s when the options’ strike price is close to the current stock price.

At first glance, a straddle seems like a no-brainer. It looks as though you can profit whether a stock rises or falls.

But the truth is, you need the right conditions for it to be worth it. Otherwise, it’s just an expensive strategy that won’t pay off.

Yet there’s a variation on the theme that can tilt the odds more in your favor. And that’s what I’d like to look at today…

Cheaper Premiums

This alternative strategy is called a “strangle.” It’s like a straddle with one major difference…

A strangle uses both a call and a put option with the same expiration date. But the put and call options have different strike prices.

You buy a call option with a strike price above the current stock price while buying a put option below the current stock price.

So, for example, say a stock is trading at $100. You might simultaneously buy a call option with a $110 strike price and a put option with a $90 strike price. (You can vary these strike prices to best match your market view.)

Because both options are out-of-the-money (OTM), a strangle is cheaper to do than a straddle.

Of course, there’s a catch. The underlying stock price has to move further in order for the trade to turn a profit.

So let’s look at an example of how a strangle works…

A Strangle in Action

With the SPDR S&P 500 ETF (SPY) trading around $600, you think it’s about to break out – but you’re not sure in which direction. So you decide to buy a strangle.

You simultaneously buy a SPY $610 call option for $7.50 and a SPY $590 put option for $7.50 (a total cost of $15. (Recall that an option covers 100 shares, so this comes out as $1,500.)

Check out the chart below…

SPDR S&P 500 ETF (SPY)

Source: e-Signal

For you to profit from the trade, SPY needs to be trading in one of two directions:

Above $625 – that’s the call option strike price ($610) plus the cost of the combined premiums ($15). Remember that you’ve got to recoup the cost of buying both options.

Or…

Below $575 – that’s the put option strike price ($590) minus the cost of the combined premiums ($15).

By comparison, a straddle with strike prices of $600 would cost around $20 in combined premiums (or $2,000). So you’d have a $620 breakeven if SPY rallies or a $580 breakeven if SPY falls.

As you can see, it’s a trade-off.

The strangle is cheaper, but SPY must move $5 further than the straddle before the trade goes into profit.

So the key with a strangle is to have a strong conviction about the size of the potential move.

Understanding the Risks

As with any trading strategy, you must understand the risks…

A strangle is cheaper to implement than a straddle, but you’re still paying out two lots of premium.

And if the anticipated move doesn’t pan out within the expected time frame, it’s often best to exit the position before time erodes the value of your options.

Volatility plays an important role in a strangle as well. It affects the value of both call and put options.

That’s why you want to buy a strangle when volatility is low but increasing. And you’d aim to sell when volatility is high.

Get this right, and it can greatly enhance your chances of closing your strangle out for a profit.

Happy Trading,

Larry Benedict
Editor, Trading With Larry Benedict