The world of options trading offers a vast array of strategies for investors to navigate market movements in India. For those seeking to capitalise on significant volatility, the strangle emerges as a potentially rewarding, yet calculated, approach. This blog delves into the intricacies of the strangle strategy in options trading, explaining its mechanics, potential benefits, and inherent risks.
What is a strangle?
A strangle is an options strategy involving the simultaneous purchase of both a call option and a put option on the same underlying asset but with different strike prices and the same expiration date.
- Call Option: Grants the right, but not the obligation, to buy the underlying asset at a specific price (strike price) by the expiration date.
- Put Option: Grants the right, but not the obligation, to sell the underlying asset at a specific price (strike price) by the expiration date.
Key characteristics
- Different Strike Prices: Unlike a straddle (which uses the same strike price for both options), a strangle utilises higher and lower strike prices compared to the current market price for the call and put options, respectively.
- Same Expiration Date: Both the call and put options in a strangle strategy share the same expiration date.
Why use a strangle?
Investors typically deploy a strangle when they anticipate significant volatility in the price of the underlying asset but are uncertain about the direction of the movement (up or down).
- Profit Potential: A strangle offers the potential for profit if the price of the underlying asset experiences a substantial move in either direction before the options expire.
Understanding the payoff
- Stock Price Goes Up Significantly: If the stock price surges above the call option's strike price, you can exercise the call option to purchase the stock at a lower price and sell it at the higher market price, pocketing the difference.
- Stock Price Goes Down Significantly: If the stock price plummets below the put option's strike price, you can exercise the put option to sell the stock (even if you don't own it) at a predetermined price and then buy it at the lower market price, profiting from the price disparity.
Example
Imagine you believe a stock's price is poised for significant movement in the coming months, but you're unsure if it will rise or fall. You could implement a strangle by:
- Buying a call option with a strike price of ₹120 (above the current market price of ₹100)
- Buying a put option with a strike price of ₹80 (below the current market price)
Profit scenarios
- Stock Price Soars Above ₹120: Exercise the call option to buy at ₹120 and sell at the higher market price for a profit.
- Stock Price Dives Below ₹80: Exercise the put option to sell at ₹80 and buy at the lower market price, profiting from the price difference.
Risks of a strangle in options trading
While a strangle presents potential for significant gains, it's crucial to understand the inherent risks:
- Cost: Strangles involve buying two options contracts, making them potentially more expensive compared to other strategies.
- Time Decay: The value of options contracts deteriorates over time (time decay). Strangles are best suited for situations where you anticipate price movement within a defined timeframe.
- Limited Profit Potential: Unlike a straddle, profits in a strangle are capped by the difference between the strike prices minus the premium paid for both options.
- Potential for Loss: If the underlying asset's price remains relatively flat or moves within a narrow range between the strike prices, you lose the entire premium paid for both options contracts.
Conclusion
The strangle strategy caters to experienced options traders comfortable with volatility and the potential for substantial losses. Before employing a strangle, ensure you thoroughly understand the risks involved and conduct in-depth research on the underlying asset. Remember, successful options trading hinges on careful planning, risk management, and a deep understanding of market dynamics.
