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

Nilesh Jain

29 Mar 2017

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.


Have Referral Code?

Similar articles

  • Responses
  • Patidar Samaj

    - 2 hrs ago

    This article claims RJio was given a "Backdoor Entry" into the 4G Based Voice Routing. The peculiar aspect is without the Voice License, Rjio would have been a mere ISP. With the license, it is now a holistic communications service provider, with ability to exponentially scale the bouquet of products. The events indicate it was meticulously planned way before the auctions because the auctions were clear on the agenda: 4G for internet only.

Load More
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. 


Banner

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

Nilesh Jain

29 Mar 2017

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.


Have Referral Code?