An insight into straddles, strangles and collars

How investors can use straddles, strangles and collar strategies when investing.

Options give investors the right, but not the obligation, to buy or sell a security at a pre-agreed price in the future. Whilst purchasing a single option can provide exposure to price rises (call options) or price falls (put options), straddles, strangles and collars are option strategies that combine two options to achieve different payoff profiles depending on market views.

Straddles and strangles are two similar strategies that investors can use when they expect prices to move from current levels, but they are unsure whether the price will rise or fall. Both strategies consist of buying a call option and a put option. The buyer of a straddle or strangle expects a big move in the underlying security price with the aim that if the security moves sufficiently in one direction, the profit on that leg of the transaction will exceed the loss on the other leg, resulting in a net profit. Both strategies also reflect a view that the price of the security will become more volatile.

With straddles and strangles the maximum loss is the combined cost of the two options. The difference between a straddle and a strangle is that the straddle uses at-the-money options, whilst the strangle involves the purchase of out-of-the-money options. For example, a two-month straddle on QBE shares, which are currently priced at $10, would require the purchase of a two-month call option, exercisable at $10, and the purchase of a two-month put option, also exercisable at $10, which would cost about $0.66 in total option premiums. If the QBE share price stays at $10 then the straddle loses $0.66 on 27 September 2018 when the options expire. If the share price rises above $10.66 or falls below $9.34 then the straddle becomes profitable. A strangle over QBE could involve the purchase of a call option exercisable at $10.50 and a put option exercisable at $9.50, which would only cost about $0.31 in total option premiums. Although this is cheaper than the straddle strategy, it requires a slightly larger move in the underlying share price to earn a profit (i.e. above $10.81 or below $9.19).

Alternatively, investors can sell a straddle or strangle (known as a short straddle or short strangle) if they have the view that prices will not move much and be range-bound. In this scenario, they would sell each of the options, collect the option premium and hope that the price does not rise or fall much over the term of the options.

Collars on the other hand are option strategies used where someone holds the shares but wishes to protect against large price movements on the shares over a period of time. The collar involves purchasing an out-of-the-money put option and selling an out-of-the-money call option. A zero-cost collar is one where the income used from selling the call option is used to pay for the purchase of the put option, so that there is no cost to the investor using the collar. The investor is exposed to price fluctuations in between the exercise prices of the put and call options, but has no exposure to larger price rises or falls as the options will be exercised and the shares sold if the price move is large enough. Zero-cost collars are useful for investors that may want to borrow against shares without risk of a margin call, or may want to reduce exposure to a large shareholding without necessarily selling the shares.

 

QBE Insurance Option Straddle Payoff

 

 

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