Mastering Derivatives: Straddle/Strangle — Switching Futures For One Leg

You can set up a straddle or a strangle to take a near-pure bet on volatility. Both require going long on a call and a put of the same expiry on the same underlying. A straddle requires the use of same-strike call and put whereas a strangle involves out-of-the-money (OTM) call and put. The premise to set up either strategy is your view that the underlying will move up or down by a long distance, without a directional bias. But what if you have a marginal direction bias? This week, we discuss why futures can be switched for option on one leg based on your directional bias. 

Switch Straddle/Strangle

Suppose the outcome of a significant event is expected to be announced soon. If the outcome is as expected, the underlying is likely to climb up sharply. If the outcome is adverse, the underlying could fall but not so much as the move up. So, there is a marginal upward bias. This argument could work at a macro level or at a company-specific level relating to earnings, merger/acquisition or an important strategic alliance. 

Now, given the marginal upward directional bias on the underlying, you could consider substituting futures for a call option. Why? Futures price moves one-to-one with the underlying whereas a call option cannot. This is because the time value of an option decays with each passing day. So, an increase with the underlying price in response to a positive outcome can lead to greater gains on the futures compared to the call. 

That said, how should you decide whether to set up an at-the-money (ATM) put or an OTM put for other leg, given the directional upward bias? The decision could be based on the implied volatility of put strikes and their premiums. Note that implied volatility is a component of time value of an option, and that the time value decays to zero at expiry. So, it is important that you do not pay too much for the time value of an option, as that is a loss for you. That means you need to go long on a put that has lower implied volatility among the two or three strikes that you select, preferably the near-ATM strike and two immediate OTM strikes. Note that farther the selected strike is from the current futures price, greater the loss on the futures position if an adverse outcome were to happen, although the long put may gain some to cushion the losses. 

Optional Reading

You should close the position immediately after the outcome of the event is known, for two reasons. One, the position was set up to take a bet on the outcome of the event. And two, keeping the position longer will lead to more time decay on the put position. Note that the position allows for lower initial margin on the futures position, as the long put can cap the losses on the long futures when the underlying declines.

(The author offers training programmes for individuals to manage their personal investments)

Published on August 30, 2025

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