This week, we discuss Strangle, a volatility strategy that can be set up to trade events whose outcomes are uncertain. The position can also be created to capture expected breakout and breakdown in an underlying following a price congestion.

Lower outlay

A strangle can be set up by going long on an out of the money (OTM) call and an OTM put on the same underlying for the same maturity. The outlay for setting up this strategy is significantly lower than that of a straddle, which is set up with at-the-money options. The flip side is that the position will be profitable only if there is substantial movement in the underlying.

Suppose the underlying currently trades at 14910 and you decide to buy the 15000 call and the 14800 put on the underlying. The strikes should preferably be the ones immediate to the ATM (at the money) option. We chose the next strike because the 14950 call and the 14850 put are not actively traded on the Nifty index. The cost to set up this trade is 326 points. This means that the underlying has to move above 15326 or decline below 14474 for the position to be profitable at option expiry.

Given that OTM options consist only of time value, the position suffers from high time decay. This means that a strangle will lose significant value with each passing day. So, either the call or the put has to gain substantially through intrinsic value to recover losses from time decay and then generate gains on the position.

You can apply the following rules to set up a strangle: One, buy short-dated options. This is because the position’s profit will be generated through intrinsic value of the option. So, the OTM option will become deep ITM (in the money) following the sharp movement in the underlying.

But deep in-the-money options are not actively traded; you may have to exercise the option and short-dated options come in handy because you can capture the intrinsic value before the underlying dramatically reverses direction following a favourable movement.

Two, identify assets with price congestion. These are good candidates for possible volatility explosion (increase in volatility). One way to create such a list is to run filters for stocks trading with narrow Bollinger Bands. You can also set up filters for event-based trades. Third, determine the upside and the downside price targets for the stock and for index futures if you want to trade index options (as spot index is not a tradable asset).

Finally, compare the expected movement in the underlying with the cost of setting up the strangle. In the above case, you had to pay 326 points to set up the strangle.

If your price target is more than 326 points above or below the current price of the underlying, the strangle is meaningful to set up. Otherwise, it is not.

Option reading

Many individuals believe that if you buy a call and a put, you are sure to generate profits because the underlying has to either climb up or decline. That is not true. The underlying can move sideways. And if even if the underlying moves up or down, the breakout or breakdown should happen sooner than later. If not, straddle and strangle will suffer losses. Note that you can be biased to the upside or to the downside. In an event-based trade, you may believe that a positive outcome is more likely than a negative outcome. In such cases, you can buy two ATM calls and one ATM put. Such a position is called strap. If you have a negative bias, then you can set up a strip - buy two ATM puts and one ATM call. The outlay is very high, and both the strap and the strip suffer from high time decay. You can also ratio a strangle - buy more calls than puts or the other way depending on your marginal directional bias.

The writer offers training programmes for individuals to manage

their personal investments

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