Strangle Option Strategy is to hold opposite positions in the same stock to make a profit while minimizing risk
One of the popular strategies amongst avid investors is the Strangle Option Strategy; it helps in making a good profit while minimizing your risk at the same time. Through this article I’ll be explaining the basics of the strangle strategy; and how to apply the same in a real-world scenario.
You have to choose a range for yourself within which you expect the underlying to stay. Aggressive investors can choose a smaller range; while conservative investors can choose a wider range to stay safe in case of fluctuations in the market.
There are 2 kinds of Strangle Option Strategies that we are going to discuss in this post today. Short-Strangle and Long-Strangle.
Short Strangle Strategy
One should apply Short Strangle Option Strategy when he expects the market to remain within a certain range; and expects nothing too extreme to happen. For our example, let’s assume our investor is an aggressive one; and they expect the market (NIFTY) to stay between 9000 and 9500 levels.
Below are the premiums for respective call and put options expiring in 1 month. (Note: you have to use put option for the lower limit and call option for the upper limit);
- 9000 PE – INR 300
- 9500 CE – INR 125
In this strategy, the investor will sell both the options (“Short” Strangle) and earn INR 425 today.
Fast forward to the date of option expiry:
Either of the below 3 things can happen:
Scenario 1: Market between 9000 and 9500 – both the options will expire without getting exercised, The investor will keep the premium. Total earning – INR 425.
Scenario 2: Market over 9500 – Investor will start losing money on the call option as it is in-the-money. But remember, he sold both call and put options and earned 425 premium, right? So the market will have to go at least 425 points beyond 9500 before he starts losing money. The investor will stay in profit as long as the market stays below 9925 points.
Scenario 3: Market below 9000 – Investor will start losing money as the put option is in-the-money. But since he has already earned 425 before, the investor will stay in profit as long as the market doesn’t fall below 8575 points.
Conclusion: The investor will stay in profits as long as the market remains between 8575 and 9925 points. So he has a wide range in which to play in the market without losing money.
Long Strangle Strategy
An investor should apply Long Strangle Option Strategy when he expects an extreme good or an extreme bad news to break in the market which would either take the market below a lower limit (for bad news) or above an upper limit (for good news) but the investor is not sure which of the two scenarios may happen.
We will use the same range (9000 to 9500) and the same option premiums that we used in our last example.9000 PE – INR 3009500 CE – INR 125
Now let’s assume that the investor is in two minds regarding the release of COVID-19 vaccination:1. Market will improve if scientists discover a vaccination (go above 9925)2. Market will go down if the scientists don’t figure out a solution and economy collapses (go below 8575)
In this case, the investor will purchase both the call and put options and pay total premium of INR 425 today.
Now, at the time of expiry of the options
If the market stays between 9000 and 9500 then the investor will lose INR 425 (maximum loss). Otherwise, either of the below cases can happen:
Scenario 1: COVID-19 vaccination is discovered and the market improves rapidly going beyond 9925. The investor will make a profit if the market goes above 9925. Upside is unlimited in this case.
Scenario 2: COVID-19 vaccination is not discovered and the market goes below 8575. The investor will make a profit if the market goes below 8575. Upside is unlimited in this case as well.
Scenario 3: There is not much fluctuation in the market and the index remains between 8575 and 9925 points. In this case the investor will make a loss but his maximum loss will be limited to the amount of total premium that he has already paid. Maximum loss of INR 425.
Strangle Strategy provides a good way to make money in the market but the investor will have to wisely choose a range for themselves so that they make money instead of losing it. An aggressive investor may choose a smaller range (9000 to 9500 in our case) while a conservative investor may choose a wider range.
One important point to note is that in case of Short Strangle Strategy the downside is unlimited if the investor is not careful while choosing his range. Therefore, every investor should know the associated risks and the amount of risk that they are taking in the stock market before jumping into the game.
Hope the above knowledge proves to be useful to you! Please share your experiences/feedback in the comment section below.
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