How to Create an Option Straddle, Strangle and Butterfly

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One of the advantages of option strategies is that you can create a system with a guaranteed downside risk. That is you can create risk-defined trades. In the highly volatile and uncertain markets that we are seeing of late, stop losses and offsetting hedge trades cannot always be relied on to guard against losses.

Trades with “inbuilt downside” are one of the main reasons for using options and option strategies.

Straddle and spread options
Straddle and spread options © forexop

The Strangle

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.

The Straddle

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

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.

Long call butterfly spread on EUR/USD
Long call butterfly spread on EUR/USD © forexop

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.

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About the Author

Kevin Ott Kevin is an active trader, alternative investor, and traveler, having retired after spending several years as a financial market analyst. Kevin is familiar with all market instruments, whether it's Shanghai equity index futures, Italian distressed debt, or Latin American currency options. When he’s not trading and writing research reports for fun, he can be found surfing and exploring uncharted islands in Indonesia eating a sandwich in Manhattan.

5 Comments
  1. HI Kevin,

    I am so glad you put me on the margin maximisation trail.

    I checked twice with my broker IB team and the two products -spot fx and CME currency futures – are treated separately which means no benefit in terms of initial margin . I would end up paying roughly a total of about 19% initial margin. But P&L will be treated for all assets and so there will be some relief for me . Not until I have put up the additional margin for futures trading.

    However, I was told, as long as I used spot fx to trade any other pair, margin will be treated as one.

    I looked around a few onsites for real-time data on currency correlation.

    From myfxbookall’s real-time correlation data (maximum one month available) I found top positive 4 correlational pairs in last month are: GBPSGD, 94.5, GBPCHF 94.2, USDJPY 88.2, EURJPY 85.9%.

    Now how I am lost.

    What factors cons and pros should I consider before using this spot route for hedging to minimise margin?

    Besides hedging, do you think it will be worthwhile to do straddle trading if you have a definite view about
    range-trading or mean-reversion tendency pair, their direction and reversal or major pullback?

    Looking forward to benefit from your vast experience.

  2. Thank you so much for your detailed reply. It helped me immensely. I would now avoid trading GBPJPY futures unless they introduce options for the same cross pair. I did not do my due diligence . They have introduced
    the cross pair very recently and even the customer service guys at the broker’s place are not aware of its existence.

    I am a retiree and have chosen to sell currency options as a home-based venture. A friend of mine taught me to trade options in an hour and I got hooked to it because of its simplicity and requiring no particular specialised knowledge. The only part to handle is risk management for which he told me no further study is required. I must do some paper trading practice for rolling over adjustments and handle the online platform for posting trades. It was difficult to find a real-time paper trading account because of CME putting restrictions on free data usage. IB offers you a real-time paper trading account if you open a trading account (they call it production account) by depositing US$10,000 minimum. You can’t access real-time CME data if you are operating trading account. But if you are not going to operate the trading account for 3 months also you get CME real-time
    data plus use of IB trading platform to test trading strategies.

    I want to do fx options trading – splitting in two streams. Presently my 2 year experience is in Directionless fx options trading – 15 delta OTM strangles only.

    My search for directional fx trading took me to your articles. You write so well. If you have written any book,
    I am willing to buy.

    More than 40 spread strategies are being touted by stock options educators. Which of those will work on fx directional trade? Please write something on what could be good and valid spread strategies for directional trades for fx .

    Strangles have not failed me during last two years. I am quite happy with them. I have also handled risk management using inverted ITM strangles without any difficulty even when EURUSD has risen for up to 500
    pips consecutively in a matter of 4 days. Sometimes doing 5 extrad positions to handle risks. So margin buffer
    is very critical. Return is 100% per annum but I lack funds for buffer margin.

    Because it needs deep pockets I want to do directional spread trading. Would you please write an article on which directional strategies will really work on currency futures options? Spot fx gives me stress and I want to stick to currency futures options only.

    I am grateful to you for taking out time to write in detail.

  3. Hi Kevin,

    You are providing invaluable simple to understand education on fx options. Thank you.

    I am a GBPJPY futures trader and want to protect from the downside by using options. But CME offers
    no options on this pair and the OTC options spread is too wide almost 25 pips and so it is not workable.
    I have sold GBPJPY futures on CME . What should I do to hedge in such a situation. Even if I use two
    pairs JPYUSD and GBPUSD i still save a lot of spread. The spread on each pair is 2 to 3 pips.

    So how the margin will work and how should I trade? Should I buy put to protect downside of short GBP and
    sell JPY call to hedge long side of JPY? I am confused . Can you please write something on this on how to hedge such currency pairs futures on CME.

    • Hi Peejay,

      I’m glad you find this article helpful.

      Although there are no easily accessible options for spot GBP/JPY, the CME offers options on both GBP and JPY futures. They are highly liquid with plenty of open interest. If you use these options, however, you would effectively be trading two separate currency pairs, GBP/USD and JPY/USD, because the futures are traded in the US dollar. And as you point out, you will have a little bit of slippage when doing this. Despite this, it seems to be the best option for your situation. On the CME, GBP futures are represented by the symbol “6B” and JPY futures are “6J”.

      So, in an attempt to answer your question, I think you have two options:

      The first option is to continue trading spot GBP/JPY and use GBP and JPY futures options traded on the CME to hedge these positions. Depending on CME portfolio margining, margin requirements might work out in your favor if you maintain a position in the spot currency pair. However, this might depend on your broker and account specifications and since futures and forex are two different instruments, you would have to see what the margining is for yourself in your own account. A simple phone call to your broker’s trading desk will clairify this.

      The second option you have is to trade your strategy entirely using CME futures. This is possible, but likely not as effective.

      If you are buying (or selling) GBP futures and selling (or buying) JPY futures you would essentially be gaining the same exposure as trading the spot currency pair of GBP/USD and you would be able to hedge your positions with options. The best method of doing this would be a pairs trade (where you simultaneously buy and sell the futures) , so you could minimize unwanted slippage.

      If you are short GBP (or JPY) and want to hedge this position, you could either:
      1) buy GBP (or JPY) calls
      2) sell GBP (or JPY) puts

      Conversely, if you are long GBP (or JPY) and want to hedge, you could:
      1) buy GBP (or JPY) puts
      2) sell GBP (or JPY) calls

      I really hope this helps, and please let me know if you have any more questions.

      Thanks

      • Hi Kevin,
        Thank you very much for explaining me in details.
        I had posted comment earlier but those have not appeared.

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