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If you are expecting a major move in the price of a stock you hold (for instance, from a dramatic announcement expectation), using a straddle or strangle strategy is a good bet.
Strangles
In a strangle option strategy, the investor buys an out-of-the-money (OTM) call option and an OTM put option with the same expiration date. This strategy becomes profitable only when there is a large movement in the stock or the underlying security. For example, the Nifty closed at 5,679 on Friday. The Nifty 5,800 call option (CE) expiring on November 29 is quoting at Rs 65.70 and the 5,500 put option (PE) is quoting at Rs 33.40.
Therefore a strangle can be constructed by buying a 5,500 put and a 5,800 call with an investment of Rs 99. So at the time of expiry Nifty should either close at 5,899 (5800 + 99) or 5,401 (5500-99) for the strategy to break even. If the Nifty closes between 5,401 and 5,899, the strategy will lose all its premium.
The profit pattern obtained with a strangle depends on how close together the strike prices are.
The farther apart they are, the less the premium will be. Hence the loss is lower. But the stock price has to move farther for profit to be realized. For example, a strangle combination 5,400 put (Rs 18.75) and 5,900 call (Rs 35.30) will cost Rs 54.05, but for the strategy to become profitable Nifty has to close either at 5,346 or 5,954.
This strategy can be initiated before an event such as an earnings announcement where a large movement in stock price is likely. Traders should also avoid using this strategy in stocks where volatility is relatively low (such as in Reliance Industries) since it does not work when the stock is range-bound.
Straddle
This strategy is similar to strangle, the only difference being that the options purchased are at-the-money and hence, costlier. This strategy would also require a larger move in the stock or the index than the strangle since the premium is high.
For example, a Nifty straddle can be constructed by buying a 5,679 call and put expiring on November 29. Since Nifty calls and puts are quoted in multiples of hundred, we will consider a strangle strategy which will involve buying a 5,700 call and 5,700 put. A 5,700 call will cost Rs 112 and a 5,700 put will cost Rs 94. Thus the total investment i.e. the premium paid is Rs 206.05. For this strategy to be profitable, the index has to close either at 5,906 or 5,494.
> shaurya.mishra@thehindu.co.in
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