Let’s discuss a profitable strategy of options called Strangle I.e. Long Strange. Though we call long strangle as Strangle but it is wrong because there is a difference between Short strangle and Long strangle.
Short strangle spreads are used when little volatility is expected of the underlying stock price. Short strangle has unlimited loss making potential and limited profits while Long Strangle has unlimited profit potential and limited loss. Which one you will choose?
But our recent strings of fundamental news like demonetisation, US election skyrocketed the volatility countering each other.
It’s a neutral options strategy which means it doesn’t make bet on direction of the market. It makes the bet that market volatility in short term i.e. either it will be bullish or bearish.
Here is the trade setup –
We buy a slightly OTM (out-of-the-money) put option and a slightly OTM call option of the same underlying stock and expiration date.
Buy 1 OTM Call
Buy 1 OTM Put
When the underlying stock price moves sharply towards either upwards or downwards at expiration, we gain huge profit.
For novice traders, let me coin a term, Breakeven Point i.e. the market price that the underlying asset (indices or stock) must attain to make the option buying or seller profitable.
For Option Buyer it is Strike Price + Premium paid for buying the option.
For Option Seller it is Strike Price – Premium paid for buying the option.
So there are two breakeven points for the long strangle strategy.
So we occur the loss if the underlying asset’s price doesn’t move! The maximum loss is the premium paid while buying the options.
Here is a practical example to make it clear –
I am betting on NIFTY (Indian market index) will not stay between the range of 7950–8050 at the time of expiry of the options.
Suppose, It’s trading currently at 8,000.
We’re buying a call options of NIFTY 8050 i.e. NIFTY DEC 8050 CE and buying a put options of NIFTY 7950 i.e. NIFTY DEC 7950 PE.
Remember, if we buy 1 lot, we will get 75. 8050 CE and 7950 PE will have different strike price but you must ensure to invest the same amount of capital to stay unbiased.
Let’s say we have invested 7,500₹ on each, hence 15,000₹ all total.
If at the time of expiration NIFTY trades at 8000, both of them will expire worthless and our maximum loss of 15,000₹ will hit.
If at the time of expiration NIFTY makes a strong move and trades at 8100 on expiration, then our put options i.e. DEC 7950 PE become worthless but our call options will be having a huge profit, let’s assume 25,000₹ is DEC 8050 CE’s expiry value.
Hence, net profit is 25,000₹ – 15,000₹ = 10,000₹
*We are not calculating brokerage and other commissions in the above equations.
What if you want to bet on NIFTY will stay between the range of 7950–8050 at the time of expiry of the options. That’s when short strangle comes useful!
What comes next is optimization to probability of profit and optimization for maximizing value of the profitable amount.
What should be appropriate strike price? What should be appropriate ‘out of the money’ put and call position? There are many theories. Here is one I have discussed in the next chapter.