Option Strategies

Strangle

If you have understood the straddle, then understanding the ‘Strangle’ is quite straightforward. For all practical purposes, the thought process behind the straddle and strangle is quite similar. Strangle is an improvisation over the straddle, mainly to reduce the cost of implementation.

In a Long straddle you are required to buy call and put options of the AT-THE-MONEY (ATM) strike. However the long strangle requires you to buy Out of The Money (OTM) call and put options. Remember when compared to the AT-THE-MONEY (ATM) strike, the OUT OF-THE-MONEY (OTM) will always trade cheap, therefore this implies setting up a strangle is cheaper than setting up a straddle.

Few points to be kept in mind while initiating a long strangle are the same as initiating a long straddle. They are:

1.The volatility should be relatively low at the time of strategy execution
2.The volatility should increase during the holding period of the strategy
3.The market should make a large move – the direction of the move does not matter
4.The expected large move is time bound, should happen quickly – well within the expiry
5.Long strangle is to be set up around major events, and the outcome of these events have to be drastically different from the general market expectation.

Long Strangle

Option Chain:

Nifty Spot is trading at 16360. We Buy 1 Call and 1 Put Out of the money strike prices. Call at 16450 strike price at 64 and Put at 16250 strike price at 95 premiums respectively. Total premium which we pay to implement this strategy is 64+59 = 123. This means to be in profit from this strategy the underlying asset has to move 123 points up or down from 16360 for the trader to generate returns.

Maximum Loss: Net Premium Outflow 123

Maximum Profit: Unlimited as price rises or falls

Breakeven Point 1: Call Strike Price + Maximum Loss 16573

Breakeven Point 2: Put Strike Price - Maximum Loss 16127

When we buy calls and puts, it has a limited downside, hence the combined position also has a limited downside to the extent of the premium paid and an unlimited profit potential on movement of upside or downside direction of the asset. So, a long strangle is like placing a bet on the price action each-way– you make money if the market goes up or down, keeping in mind an increase in volatility.

Short Strangle

Now let us consider a short strangle. This is just the opposite to buying a strangle. Instead of buying Calls and put, here we sell calls and puts both Out of the money and receive premiums. The maximum profit which can be generated from this strategy is limited to the extent of the premium received. Once the price movement goes beyond the range, we start incurring a loss.

Since we are selling out of the money options, the premium received is lower, but the range increases which cushion the trader against the sudden movement of the asset. What needs to be kept in mind is that at the time of executing the strategy, there must be Volatility.

The volatility in this case needs to reduce during the holding period and should be high at the time of execution of the contract. The trader bets against the volatility to make money from this strategy. If the trader identifies a specific range in which the stock is expected to trade, and no major events are round the corner, a short strangle is a perfect strategy to execute.

Example: Short Strangle

Nifty Spot is trading at 16360. We Sell 1 call and 1 put Out of the money strike prices. Call at 16450 strike price at 64 and Put at 16250 strike price at 95 premiums respectively. Total premium which we receive when the strategy is implemented is 64+59 = 123. This means to be in profit from this strategy the underlying asset has to stay in the range of 123 points up or down from 16360.