Trades with “inbuilt downside” are one of the main reasons for using options and option strategies.
As I described in my other tutorial, iron condors, are risk-defined trades. The downside limit is known from the outset.
When you are comfortable with iron condors, strangles will be another appealing strategy.
A strangle strategy is an excellent tool in a commodity or currency trader’s portfolio.
A strangle is basically an iron condor without two of the protective option strikes. For a short strangle, a trader would sell a call while also selling a put in the same expiration month for a given underlying.
For example if you want to sell a strangle in Natural Gas futures, with Natural Gas trading at 2.50, you could sell a 2.80 call and a 2.20 put for a net credit. The width of the sold strikes can be chosen at your discretion. Meaning, you could choose to sell very low delta options or options closer to the price of the underlying with a higher delta.
One important caveat to note with short strangles is the inherent risk. Theoretically, the maximum loss is unlimited or undefined to the upside. This is because the underlying commodity or currency could go to infinity, and the maximum loss for the downside risk is capped at the underlying going to zero.
An underlying going to infinity or to zero would not be a pretty sight for a short strangle, so it is to be used with caution.
Nevertheless, a strangle can also be used in a risk defined manner. Instead of selling an out-of-the-money call and put, a trader could purchase the call and put and create what’s called a “long strangle”.
The long strangle is essentially the long iron condor without the corresponding sold put and call. For the long strangle, a trader’s maximum profit would be unlimited. The maximum loss is the amount paid for the strangle.
Ideally, a trader will purchase “a strangle” when he expects a dramatic move in the underlying, but is unsure of the direction.
Very similar to the strangle, the straddle involves either selling or purchasing the exact same strike price of an option in the same expiration month.
For a long straddle in Euro FX futures trading at 1.115, a trader could purchase both the 1.12 call and put, resulting in a risk defined trade with unlimited profit potential.
Similarly, for a short strangle the trader could sell both the 1.12 call and put, resulting in an undefined risk trade with limited profit. The undefined risk for the short straddle (as well as the short strangle) is countered with a higher probability of profit.
The butterfly is a less known and practised trade by retail investors because of its seeming complexity.
However, when you break it down, it’s relatively straightforward. A butterfly spread involves buying a call with a lower strike price. Then selling 2 calls with a greater strike price (usually at or close to the spot price), and then buying one call with an even greater strike price.
The basic concept of a butterfly spread is that it follows a ratio of 1-2-1. So a trader could do a butterfly of 50-100-50, and it would still be a butterfly. It’s therefore symmetric, hence the name “butterfly”.
Take the following example:
EUR/USD trading at 1.10
Buy 1 x EUR/USD 1.08 call at $2156
Sell 2 x EUR/USD 1.10 calls at $778.7
Buy 1 x EUR/USD 1.12 call at $157
Initial cost: -$755.70
The maximum loss: $755.70
The maximum profit: $1244
The system of trades achieves maximum profit if the underlying remains at the current price, namely 1.10. In this case, the 2 sold calls expire out of the money so the premium is collected and no payout is made. The call at 1.08 expires in the money and the call at 1.12 expires out of the money.
To calculate the maximum profit, take the difference between the strikes of the sold calls and the lower long call and add the initial cost.
(1.10 -1.08)*100,000 -755.70 = $1244
The maximum loss occurs if the price is less than 1.08 or greater than 1.12. Hence this is a strategy to use if you are expecting the underlying to remain flat.
The payoff diagram below illustrates outcomes.
Just like all of the aforementioned options strategies, a butterfly spread can either be long or short for a net debit or credit and, of course, be done for either the call or put side.