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