Option Basics -- VI

Anup Menon

Strangle strategy

ASSUME you are an investor and want to own the stock of ABC company.

You are sure that the stock will move substantially but you are not sure whether the stock will move up or down. In such circumstances can you protect your position ? Yes, the investor can consider using a long strangle strategy. As is the case of the straddle, a strangle strategy involves two separate transactions. The long strangle strategy involves a purchase of an out-of-the-money call and an out-of-the-money put option with different exercise prices, but all other terms remaining constant. The basic difference between a straddle and a strangle is that in the case of the strangle, the exercise prices are different.

As is the case with a straddle, investors using this strategy are unable to gauge the direction of the stock. Therefore, the more volatile the stock, the better the payoffs from a (long) strangle strategy and vice versa. Similarly as in the case of a straddle, investors are advised that the risk profile is similar. Therefore in the case of a strangle, the erosion is twice that of holding a call or a put option. This apart the transaction costs would also be higher as the investor has to buy twice the number of options. An example would make the strategy more clear.

First, let us look at the (long) strangle strategy. Assume that the stock of ABC is selling at Rs 100. The investor purchases one call option at a strike price of Rs 105 and one put option with a strike price of Rs 95. All other terms and conditions are the same for both options. Further assume that the investor pays a total premium of Rs 10 (5+5) for both options put together. This effectively means that the stock price has to either move beyond 110 or move below 90 for the investor to make money. If the price moves beyond Rs 110, then the call option will make money and if the price falls below Rs 90, the put option will make money. In the event of the stock price moving between Rs 90 and Rs 110, the options would be worthless and the maximum loss is set at Rs 10.

Now let us consider the (short) strangle. This is again an extremely risky strategy. For instance, as in our above example, the investor will write a call and a put option with a strike price of Rs 105 and Rs 95 respectively. He receives a total premium of Rs 10 for the risk borne by him. His maximum profit is limited to Rs 10. However if there is a substantial movement of the stock in either direction, the writer's losses are unlimited. This is an extremely risky strategy and advised only for players with substantial financial backing and experience in trading options.

The advantage from using a strangle over a straddle is that the downside is better hedged than when using a straddle.