Options as a Derivative product has gained a lot of attention over the last couple of decades. With the introduction of Derivatives trading, the common myth of old (buy before you sell) has also soon vanished. No one could take positions (long or short) depending on the market sentiments. And through this discussion, we will try to understand the Strangle Option strategy (with a special focus on Short Strangle Options Strategy). But before doing that, let us understand what options are:
“Options are derivative instruments that derive their value from the value of the Underlying Asset. An option contract gives the buyer the right to buy or sell (Call or Put) the underlying asset on or before the expiration at a pre-decided price”
Straddle Vs Strangle
Long Strangle and Long Straddle are both options trading strategies that give the buyer a chance to gain from any significant price movement without any directional bias. And this is possible only because in the case of both the strategies, you are the holder of both Call and Put Options. And on the other hand, Short straddle and short strangle are options strategies where you write both Call and Put Option simultaneously.
The Only difference lies in the selection of the strike prices. In the case of the Long Straddle strategy, the option holder buys both Call and Put Options of At the Money (ATM) strike prices and pays a premium for them. But in the case of Long Strangle, the holder (buyer) buys Out of Money (OTM) contracts for both Call and Put Options.
All the other conditions like buying both the options positions of the same underlying asset and for the same expiry and also the same number of contracts remains the same.
What is a Long Strangle?
A Long Strangle is that options trading strategy that involves buying Out of Money Call Option and Out of Money Put Option of the same underlying asset and same expiry. As we would be buying Out of Money contracts, so the cost involved to buy them would be less, but this would also mean that the movement in terms of the value of the underlying asset would also have to be higher for the strategy to make money to the buyer.
Say, if the spot price of Nifty is 18000 and we buy Out of Money Call option and Put Option of Strike price 18300 and 17700 respectively by paying a premium of 25 units each. So, the overall cost incurred to buy this strategy is 50 units. And as Out Money contracts are bought, for the buyer to make money, the point of Breakeven would be –
- If the Market goes up, then the BEP would be Out of Money Call option strike price plus the Premium paid for the strategy (18350 in this case)
- If the Market goes down, then the BEP would be Out of Money Put option strike price minus the Premium paid for the strategy (17650 in this case)
QUICK READ – Options Buying vs Selling: Which Strategy to Use?
What is a Short Strangle Option Strategy?
The Short Strangle Options strategy is the exact opposite of the Long Strangle. And this strategy gets created by the counterparty of the Long Strangle contracts. These are the writers/sellers to Long Strangle.
A Short Strangle Options Strategy is employed when a trader writes an Out of Money Call option and an Out of Money Put option simultaneously. The strategy is employed for the same underlying asset and with the same expiration date
Following are some of the characteristics under the Short Strangle Option Strategy
- This strategy is used when one is not expecting major movement in the price of the underlying asset.
- The short strangle strategy could potentially incur huge loss if the share prices move substantially.
The main objective behind the strategy of short strangle is that the strategy holder is of the view that the price of the underlying asset is unlikely to experience major movement and they are more than likely to stay within the strike prices selected.
Payoff under Short Strangle Options Strategy
- The Maximum loss in this strategy is theoretically unlimited because the price of the underlying asset can go up or fall down to any extent.
- The Maximum profit in this strategy is to the tune of the premium received at the time of entering of this strategy.
To Understand the Payoff
Say, the spot price of Nifty is 18500, and I am willing to enter into a short strangle strategy. Following are the option position sold-
- An Out of Money Call Option (18750 Ce) sold and premium received = 35 units
- An Out of Money Put Option (18250 Ce) sold and premium received = 35 units
So, at the time of entering this strategy, the net inflow would be 70 units. And this sounds a very lucrative proposition considering, the market needs to move a minimum of 2% to be making money for Call and Put Option buyers, which means it has to move 2% to begin to cost us.
Breakeven Point for us would be (upside) = 18750 + 70
Breakeven Point on downside = 18250 – 70
So, as long as the market stays between the range of 18820 and 18180, the short strangler would not lose money.
To conclude on Short Strangle Option Strategy
- Short Strangle strategy is useful one is not expecting any major move in the prices of the underlying asset
- There is inflow of capital at the time of entering of the strategy as we would be writing both call and put options.
- If the market starts to go up, then the Breakeven Point is the summation of Call option strike price and the total premium received.
- And, if the market starts to go down, then the breakeven point is the difference between Put Option strike price and the premium received
So, Short Strangle Option Strategy makes a lot of sense if you are not expecting any major movement in the price of the underlying asset within the stipulated time. Happy Investing and Money Making !!
Hitesh Singhi is an active derivative trader with over +10 years of experience of trading in Futures and Options in Indian Equity market and International energy products like Brent Crude, WTI Crude, RBOB, Gasoline etc. He has traded on BSE, NSE, ICE Exchange & NYMEX Exchange. By qualification, Hitesh has a graduate degree in Business Management and an MBA in Finance. Connect with Hitesh over Twitter here!
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