Article

How to make Profit in a Volatile Market at low cost - Long Strangle Option Strategy

14 Jul 2017 Nilesh Jain

A Long Strangle strategy is one of the simplest trading strategies, which can be used to make profit in an extremely volatile market. A Long Strangle is a slight modification of the Long Straddle strategy and also cheaper to execute as both the calls and puts are Out-the-Money. It can generate good returns when the price of an underlying security moves significantly in either direction. It means that you don’t have to forecast the trend of the market, but you have to bet on the volatility.

When to initiate a Long Strangle?

If you believe that an underlying security is going to make a move because of any events, such as budget, monetary policy, earning announcements etc, then you can buy OTM call and OTM put option. This strategy is known as Long Strangle.

How to construct a Long Strangle Option strategy?

Long Strangle is implemented by buying Out-the-Money call option and simultaneously buying Out-the-Money put option of the same underlying security with the same expiry. Strike price can be customized as per convenience of the trader but the call and put strikes must be equidistant from the spot price.

Strategy

Buy OTM Call and Buy OTM Put

Market Outlook

Significant volatility in underlying movement

Motive

Capture a quick increase in implied volatility/ big move in underlying assets

Upper Breakeven

Strike price of Long call + Net Premium Paid

Lower Breakeven

Strike price of Long put - Net Premium Paid

Risk

Limited to Net premium paid

Reward

Unlimited

Margin required

Limited to the premium paid

Let’s try to understand with an example:

Nifty Current spot price Rs

8800

Buy OTM Call Strike Price Rs

9000

Premium Paid (per share) Rs

40

BUY OTM Put Strike price Rs

8600

Premium Paid (per share) Rs

30

Upper breakeven

9070

Lower breakeven

8530

Lot Size

75

Suppose, Nifty is trading at 8800. An investor Mr A is expecting a significant movement in the market, so he enters a Long Strangle by buying 9000 call strike at Rs 40 and 8600 put for Rs 30. The net premium paid to initiate this trade is Rs 70, which is also the maximum possible loss. Since this strategy is initiated with a view of significant movement in the underlying security, it will give the maximum loss only when there is very little or no movement in the underlying security, which comes around Rs 70 in the above example. Maximum profit will be unlimited if it breaks the upper and lower break-even points. Another way by which this strategy can give profit is when there is an increase in implied volatility. Higher implied volatility can increase both call and put’s premium.

For the ease of understanding, we did not take in to account commission charges. Following is the payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry NIFTY closes at

Net Payoff from Call Buy (Rs)

Net Payoff from Put Buy (Rs)

Net Payoff (Rs)

8300

-40

270

230

8400

-40

170

130

8500

-40

70

30

8530

-40

40

0

8600

-40

-30

-70

8700

-40

-30

-70

8800

-40

-30

-70

8900

-40

-30

-70

9000

-40

-30

-70

9070

30

-30

0

9100

60

-30

30

9200

160

-30

130

9300

260

-30

230


Impact of Option Greeks:

Delta: The net delta of a Long Strangle remains close to zero. The positive delta of the call and negative delta of the put are nearly offset by each other.

Vega: A Long Strangle has a positive Vega. Therefore, one should buy Long Strangle spreads when the volatility is low and expect it to rise.

Theta: With the passage of time, if other factors remain same, Theta will have a negative impact on the strategy, because option premium will erode as the expiration dates draws nearer.

Gamma: Gamma estimates how much Delta of a position changes as the stock prices changes. Gamma of the Long Strangle position will be positive since we have created long positions in options and any major movement on either side will benefit this strategy.

How to manage risk?

A Long Strangle is exposed to limited risk up to premium paid, so carrying overnight position is advisable but one can keep stop loss to further limit losses.

Analysis of Long Strangle spread strategy

A Long Strangle spread strategy is best to use when you are confident that an underlying security will move significantly in a very short period of time, but you are unable to predict the direction of the movement. Maximum loss is limited to debit paid and it will occur if the underlying stocks remain between the two buying strike prices, whereas upside reward is unlimited.


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How to make Profit in a Volatile Market at low cost - Long Strangle Option Strategy

14 Jul 2017 Nilesh Jain

A Long Strangle strategy is one of the simplest trading strategies, which can be used to make profit in an extremely volatile market. A Long Strangle is a slight modification of the Long Straddle strategy and also cheaper to execute as both the calls and puts are Out-the-Money. It can generate good returns when the price of an underlying security moves significantly in either direction. It means that you don’t have to forecast the trend of the market, but you have to bet on the volatility.

When to initiate a Long Strangle?

If you believe that an underlying security is going to make a move because of any events, such as budget, monetary policy, earning announcements etc, then you can buy OTM call and OTM put option. This strategy is known as Long Strangle.

How to construct a Long Strangle Option strategy?

Long Strangle is implemented by buying Out-the-Money call option and simultaneously buying Out-the-Money put option of the same underlying security with the same expiry. Strike price can be customized as per convenience of the trader but the call and put strikes must be equidistant from the spot price.

Strategy

Buy OTM Call and Buy OTM Put

Market Outlook

Significant volatility in underlying movement

Motive

Capture a quick increase in implied volatility/ big move in underlying assets

Upper Breakeven

Strike price of Long call + Net Premium Paid

Lower Breakeven

Strike price of Long put - Net Premium Paid

Risk

Limited to Net premium paid

Reward

Unlimited

Margin required

Limited to the premium paid

Let’s try to understand with an example:

Nifty Current spot price Rs

8800

Buy OTM Call Strike Price Rs

9000

Premium Paid (per share) Rs

40

BUY OTM Put Strike price Rs

8600

Premium Paid (per share) Rs

30

Upper breakeven

9070

Lower breakeven

8530

Lot Size

75

Suppose, Nifty is trading at 8800. An investor Mr A is expecting a significant movement in the market, so he enters a Long Strangle by buying 9000 call strike at Rs 40 and 8600 put for Rs 30. The net premium paid to initiate this trade is Rs 70, which is also the maximum possible loss. Since this strategy is initiated with a view of significant movement in the underlying security, it will give the maximum loss only when there is very little or no movement in the underlying security, which comes around Rs 70 in the above example. Maximum profit will be unlimited if it breaks the upper and lower break-even points. Another way by which this strategy can give profit is when there is an increase in implied volatility. Higher implied volatility can increase both call and put’s premium.

For the ease of understanding, we did not take in to account commission charges. Following is the payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry NIFTY closes at

Net Payoff from Call Buy (Rs)

Net Payoff from Put Buy (Rs)

Net Payoff (Rs)

8300

-40

270

230

8400

-40

170

130

8500

-40

70

30

8530

-40

40

0

8600

-40

-30

-70

8700

-40

-30

-70

8800

-40

-30

-70

8900

-40

-30

-70

9000

-40

-30

-70

9070

30

-30

0

9100

60

-30

30

9200

160

-30

130

9300

260

-30

230


Impact of Option Greeks:

Delta: The net delta of a Long Strangle remains close to zero. The positive delta of the call and negative delta of the put are nearly offset by each other.

Vega: A Long Strangle has a positive Vega. Therefore, one should buy Long Strangle spreads when the volatility is low and expect it to rise.

Theta: With the passage of time, if other factors remain same, Theta will have a negative impact on the strategy, because option premium will erode as the expiration dates draws nearer.

Gamma: Gamma estimates how much Delta of a position changes as the stock prices changes. Gamma of the Long Strangle position will be positive since we have created long positions in options and any major movement on either side will benefit this strategy.

How to manage risk?

A Long Strangle is exposed to limited risk up to premium paid, so carrying overnight position is advisable but one can keep stop loss to further limit losses.

Analysis of Long Strangle spread strategy

A Long Strangle spread strategy is best to use when you are confident that an underlying security will move significantly in a very short period of time, but you are unable to predict the direction of the movement. Maximum loss is limited to debit paid and it will occur if the underlying stocks remain between the two buying strike prices, whereas upside reward is unlimited.