How to make Profit in a Sideways Market: Short Strangle strategy

Nilesh Jain

28 Mar 2017

How to make Profit in a Sideways Market: Short Strangle strategy

A Short Strangle strategy consists of one short call with higher strike price and one short put with lower strike price. It is established for a net credit and generates profit only when the underlying stock expires between two strikes sold. Every day that passes without large movement in the underlying assets will benefit this strategy due to time erosion. Volatility is a vital factor and it can adversely affect a trader’s profits in case it goes up.

When to initiate a Short Strangle strategy?

A Short Strangle strategy should only be used when you are very confident that the security won’t move in either direction because the potential loss can be substantial if that happens. This strategy can also be used by advanced traders when the implied volatility goes abnormally high and the call and put premiums may be overvalued. After initiating Short Strangle, the idea is to wait for implied volatility to drop and close the position at a profit. Inversely, this strategy can lead to losses in case the implied volatility rises even if the stock price remains at same level.

How to construct a Short Strangle strategy?

A Short Strangle strategy is implemented by selling Out-the-Money Call option and simultaneously selling 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 Sell OTM Call and Sell OTM Put
Market Outlook Neutral or very little volatility
Motive Earn income from selling option premium
Upper Breakeven Strike price of short call + Net Premium received
Lower Breakeven Strike price of short put - Net Premium received
Risk Unlimited
Reward Limited to Net Premium received (when underlying assets expires in the range of call and put strikes sold)
Margin required Yes

Let’s try to understand with an example:

Nifty Current spot price Rs 8800
Sell OTM Call Strike Price Rs 9000
Premium Received (per share) Rs 40
Sell OTM Put Strike price Rs 8600
Premium Received (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 very little movement in the market, so he enters a Short Strangle by selling 9000 call strike at Rs 40 and 8800 put for Rs 30. The net upfront premium received to initiate this trade is Rs 70, which is also the maximum possible reward. Since this strategy is initiated with a view of no movement in the underlying security, the loss can be substantial when there is significant movement in the underlying security. The maximum profit will be limited to the upfront premium received, which is around Rs 5250 (70*75) in the example cited above. Another way by which this strategy can be profitable is when the implied volatility falls.

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

The Payoff Chart:

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: A Short Strangle has near-zero delta. Delta estimates how much an option price will change as the stock price changes. When the stock price trades between the upper and lower wings of Short Strangle, call Delta will drop towards zero and put Delta will rise towards zero as the expiration date draws nearer.

Vega: A Short Strangle has a negative Vega. This means all other things remain the same, increase in implied volatility will have a negative impact.

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

Gamma: Gamma estimates how much the Delta of a position changes as the stock prices changes. Gamma of the Short Strangle position will be negative as we are short on options and any major movement on either side will affect the profitability of the strategy.

How to manage risk?

Since this strategy is exposed to unlimited risk, it is advisable not to carry overnight positions. Also, one should always strictly adhere to Stop Loss in order to restrict losses.

Analysis of Short Strangle strategy:

A Short Strangle strategy is the combination of short call and short put and it mainly profits from Theta i.e. time decay factor if the price of the security remains relatively stable. This strategy is not recommended for amateur/beginner traders, because the potential losses can be substantial and it requires advanced knowledge of trading.




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mutual-fund

Why to Choose Mutual Funds Instead of Directly Investing Into Equities?

Whether to invest in equities or mutual funds is a question that has plagued every investor. As someone who needs the best value for his/her investment should you invest in equity directly or via mutual funds?

Let’s start by first understanding what these two terms ‘equities’ and ‘mutual funds’ stand for-

Equities- Equities generally represent ownership of a company. If you own any equity in a company, you are a part owner of the said company (depending on how much equity you own).

Mutual Funds – It is an investment scheme which is professionally managed by an asset management company. It pools together the resources of a group of people and invests their money in equities, debentures, bonds and other securities.

Why choose mutual funds over equities?

For people who’ve never invested in either stocks or mutual funds, it is hard to know which is better and where to start. Broadly speaking, if you are a novice investor, mutual funds are not only less risky but also way easier to manage. Here are some ways in which investing in mutual funds is beneficial as opposed to investing in equities -

Diversification

Mutual funds provide more diversification as compared to an individual equity stock. When you invest in equity, you are investing in a single company which has its inherent risk. For example, if you invest Rs.20,000 in buying equities of one company, you could face a total loss if that particular company performs poorly in the market.  

If you invest the same amount in mutual funds, it will be invested in different kinds of stocks and financial instruments, high-risk and low-risk both, so you might not face total loss even if one company does poorly.

Scale of Investment and Lower Costs

For an individual investor buying and selling stocks is a difficult task due to its high price. Thus, any gains made from stock appreciation are nullified if the overall trading costs are considered. Comparatively with mutual funds, as the money is pooled from a large number of investors, the cost per individual is lowered.  

Another advantage of mutual funds is that you don’t need to invest large sums of money. Buying equities for a profitable venture needs huge amounts of money, a minimum of few lakhs. With mutual funds, you can start with Rs.1000 and earn profits on that as well.

Convenience

Keeping an eye on the markets everyday is a time-consuming business, especially if you are investing as a side gig. There are people who spend their lives studying the market and still end up sustaining heavy losses. Though investing in mutual funds does not guarantee high returns, it is stress-free and needs less work as compared to investing in equities.

To sum it up

It is important to remember that mutual funds have their own disadvantages as well. Thus, as with any financial decision, educating yourself and understanding the suitability of all the available options is the ideal way to invest. 


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How to make Profit in a Sideways Market: Short Strangle strategy

Nilesh Jain

28 Mar 2017

How to make Profit in a Sideways Market: Short Strangle strategy

A Short Strangle strategy consists of one short call with higher strike price and one short put with lower strike price. It is established for a net credit and generates profit only when the underlying stock expires between two strikes sold. Every day that passes without large movement in the underlying assets will benefit this strategy due to time erosion. Volatility is a vital factor and it can adversely affect a trader’s profits in case it goes up.

When to initiate a Short Strangle strategy?

A Short Strangle strategy should only be used when you are very confident that the security won’t move in either direction because the potential loss can be substantial if that happens. This strategy can also be used by advanced traders when the implied volatility goes abnormally high and the call and put premiums may be overvalued. After initiating Short Strangle, the idea is to wait for implied volatility to drop and close the position at a profit. Inversely, this strategy can lead to losses in case the implied volatility rises even if the stock price remains at same level.

How to construct a Short Strangle strategy?

A Short Strangle strategy is implemented by selling Out-the-Money Call option and simultaneously selling 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 Sell OTM Call and Sell OTM Put
Market Outlook Neutral or very little volatility
Motive Earn income from selling option premium
Upper Breakeven Strike price of short call + Net Premium received
Lower Breakeven Strike price of short put - Net Premium received
Risk Unlimited
Reward Limited to Net Premium received (when underlying assets expires in the range of call and put strikes sold)
Margin required Yes

Let’s try to understand with an example:

Nifty Current spot price Rs 8800
Sell OTM Call Strike Price Rs 9000
Premium Received (per share) Rs 40
Sell OTM Put Strike price Rs 8600
Premium Received (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 very little movement in the market, so he enters a Short Strangle by selling 9000 call strike at Rs 40 and 8800 put for Rs 30. The net upfront premium received to initiate this trade is Rs 70, which is also the maximum possible reward. Since this strategy is initiated with a view of no movement in the underlying security, the loss can be substantial when there is significant movement in the underlying security. The maximum profit will be limited to the upfront premium received, which is around Rs 5250 (70*75) in the example cited above. Another way by which this strategy can be profitable is when the implied volatility falls.

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

The Payoff Chart:

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: A Short Strangle has near-zero delta. Delta estimates how much an option price will change as the stock price changes. When the stock price trades between the upper and lower wings of Short Strangle, call Delta will drop towards zero and put Delta will rise towards zero as the expiration date draws nearer.

Vega: A Short Strangle has a negative Vega. This means all other things remain the same, increase in implied volatility will have a negative impact.

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

Gamma: Gamma estimates how much the Delta of a position changes as the stock prices changes. Gamma of the Short Strangle position will be negative as we are short on options and any major movement on either side will affect the profitability of the strategy.

How to manage risk?

Since this strategy is exposed to unlimited risk, it is advisable not to carry overnight positions. Also, one should always strictly adhere to Stop Loss in order to restrict losses.

Analysis of Short Strangle strategy:

A Short Strangle strategy is the combination of short call and short put and it mainly profits from Theta i.e. time decay factor if the price of the security remains relatively stable. This strategy is not recommended for amateur/beginner traders, because the potential losses can be substantial and it requires advanced knowledge of trading.




Have Referral Code?