The Hindu Business Line : Using Long Strangle to play volatile markets

Making money in the stock markets is an art. But making money using options is a greater art. If you are wondering why, imagine a market that moves erratically and over reacts for every piece of information that flows in; add to this the ‘time value’ factor, which constantly tries to erode your option value! But do not lose heart. Despite all these odds, you can use options profitably. All you need to do is tailor option strategies based on your market view and risk profile and monitor those positions constantly. Say, in volatile markets – apart from using long straddles (discussed in the column previously), investors can also consider using a long strangle.

A long strangle, simply put, entails buying a put option and a call option on the same underlying, with the same expiration dates and at strike prices that are out-of-the-money.

When to use this strategy?

This strategy can be considered when you foresee a volatile market and are sure of a movement in the underlying, but are not as sure about the direction of the movement. For instance, use this strategy on stock options when you are expecting some major corporate announcement, say results or some significant deal announcement. In case of index options, use it when a major market-moving announcement is expected.

While this strategy is quite similar to long straddles, note than it can be set for a lower premium outflow, courtesy out-of-money options. Out-of-the-money call options are ones that have a strike price higher than the market price of the underlying; whereas out-of-the-money put options have strike price lower than the market price of the underlying.

However, since the options are out-of-the-money, you will need a larger move in the underlying price (when compared to long straddles) to earn profits.

So, choose long strangle over the long straddle only when you want to play the likely movement in the underlying for a lower cost.

How to set the long strangle?

Long strangle can be set by buying an out-of-the-money call option and an out-of-the-money put option, keeping the current market price of the underlying as the central point. While this strategy is opted only when you have a neutral stand on the market, that is, only when you expect the underlying to move in either direction, note that you can tweak it to accommodate any slightly bullish or bearish view. You can do this by selecting a lower or higher strike price for the options that are under consideration. For instance, let us say you feel that markets next week may be volatile with some of the big IT companies expected to announce results. You can consider setting a long strangle on the index. You can do this by buying April month Nifty 4900 call trading at Rs 61 and Nifty 4600 put trading at Rs 59. Alternately, depending on your outlook, you can also set strangles by buying nifty 4800 call or 4500 put.

What will be the risk-return payoff?

Since you have only bought options, your maximum risk is limited only to the cost of setting the option spread. In this case, it will be Rs 120 (or Rs 6,000 per lot). The upside potential is unlimited. However, your option spread will turn in-the-money only when the underlying moves beyond the breakeven points.

You can calculate the breakeven points as follows:

Upside breakeven = Strike price of call option + premium outflow (in this case, 5020)

Downside breakeven = Strike price of put option - premium outflow (in this case, 4480). Between the two breakeven points, your long strangle will suffer losses, of a varying range.

The caveat

Since both the options involved in this strategy are out-of-the-money, the fate of your option position is at the mercy of market participants and their willingness to pay for the possibility that the market might move in the desired direction during the life of your options. Or simply put, with no intrinsic value, the profitability of this strategy becomes a function of time value alone. This dependence on time value makes it imperative that you close your position much before expiry if the underlying fails to move beyond the breakeven points soon.

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When to use the Long Straddle

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