Introducing Short Strangles: A 24% Per Annum Strategy!

Sometimes, the easiest ways to earn money are the ones that evade us – as our instincts are often designed to work with something we do naturally and close our minds to the obvious.  Many traders , especially post the introduction of weekly contracts on main indices, have shifted to selling options and benefit from time decay and probability. One such highly used strategy that makes consistent returns is the Short Strangle, which is advised weekly Fridays by Prabhudas Lilladher.

What is a Short Strangle?

A short strangle consists of SELLING one call with a higher strike price and one put with a lower strike. Both options have the same underlying stock and the same expiration date, but they have different strike prices typically far enough not to end out of the money, and currently typically about 600 points on weekly basis for the Bank Nifty, for instance.

A short strangle is established for a net credit (or net receipt of cash) and profits if the underlying stock trades in a narrow range between the break-even points. Profit potential is limited to the total premiums received less commissions. Potential loss is unlimited if the stock price rises and substantial if the stock price falls.

Risk and Return:

Profit potential is limited to the total premiums received less commissions. The maximum profit is earned if the short strangle is held to expiration, the stock price closes at or between the strike prices and both options expire worthless.

Potential loss is unlimited on the upside, because the stock price can rise indefinitely. On the downside, potential loss is substantial, because the stock price can fall to zero.

Creating a safe short strangle:

To reduce the risk of the strangle moving out of favor, one would want to sell just before some holidays or weekends, and of course forecast markets. And if you don’t know how to forecast, then select a strike that survives 95% of the potential weekly moves on the Nifty or Bank Nifty. In our case, currently, , an 800 point move in the Bank Nifty is a 10% probability event.

On June 14, 2019, a Friday, for instance, this trade done by writing a 800 point away call and a 800 point put (Current Bank Nifty was 30,800) would have fetched one close to Rs 76 (or 0.75% on  margin) till June 20 – the next expiry if the Bank Nifty ended between 31,600 and 30,000.

Its highly likely that one doesn’t wait for the next Thursday – as the time decay may itself allow profit booking on the first trading day next week.

Probable Move in 5 Days – Last 4 Year Data

To see a sample report from our derivatives desk,click  WEEKLY OPTION STRATEGY

Impact of change in volatility:

Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices – and strangle prices – tend to rise if other factors such as stock price and time to expiration remain constant. Therefore, when volatility increases, short strangles increase in price and lose money.

When volatility falls, short strangles decrease in price and make money. In the language of options, this is known as “negative vega.” Vega estimates how much an option price changes as the level of volatility changes and other factors are unchanged, and negative vega means that a position loses when volatility rises and profits when volatility falls.

Don’t be a Nick!

If you have been in the derivatives market for some time, you would have surely heard the now famous story of how Nick Leeson brought down Barings Bank of London. Leeson, who was heading the Barings trading desk out of Singapore, had heavily sold strangles on the Nikkei (Japanese index). Essentially, he had sold higher call options and lower put options. The logic of the trade was that the Nikkei would remain in a narrow range and therefore Barings will be able to pocket the premiums on the call and the put option. Unfortunately, things went haywire when Kobe was struck by an earthquake in 1995. The Nikkei tumbled the next day and the losses just became unmanageable for Leeson. Even as Leeson tried to escape to Europe, Barings saw its entire capital being wiped out. That is how risky short strangles can be.

Why strangles can be risky?

  • Strangle strategies are vulnerable to overnight macro risks and carry a major price risk if you are writing short strangles on individual stocks. Selling strangles on an index is a lot safer.
  • Volatility is a big risk and works against you in case of short strangles. This risk gets more pronounced when the range gets too narrow. M2M calls may start if volatility increases so you need to have buffer margins

Since you are effectively taking unlimited risk on both the upside and the downside, it is essential to keep tight stoplosses and monitor your position  – remember, a 90% probability is good enough, don’t be a warrior!

Write to us at advisorydesk@plindia.com for more information  on  these trades or to open a trading account.

 

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