Long Strangle and Short Strangle are the simplest and most commonly used strategies in the market. In the previous blog of the Beginner’s Guide to the stock market series, we have seen bear call spread and bull put spread.
In today’s article, we will understand in detail about the most simple and effective strategy used by many traders. Before going ahead, please note that you should first follow all the risk management principles while initiating these strategies, and then you should consider your entry.
So, without any delay, let’s get to the first strategy;
When you initiate a Long Strangle, you bet on both sides of the market. You will make a profit from this strategy when the market moves in either direction with momentum. In this strategy, you will buy out of the money options, and hence the cost of the strategy decreases considerably. However, your chances of profit will decrease if you buy deep out of the money options. So, it is better to keep your strikes closer to the index in order to increase your chances of profit. Also, to be at the breakeven, the underlying has to move enough in order to cover the price of both options.
Let’s consider nifty at 16300.
To initiate a Long Strangle, you have to buy one out of the money call option and one out of the money put option. While initiating the long strangle, keep in mind that your strikes should be equidistant from the spot price. Also, there should not be a skew in premiums; in simple words, the premiums of both sides should be close to each other if there is much skew in premiums, then that means the market is heavily biased in that particular direction. In such cases, it is better to avoid that trade.
Step 1 – Buy OTM Call. In our case, let’s say we buy 16500 CE, which is trading at Rs.64.
Step 2 – Buy OTM Put. In our case, let’s say we buy 16100PE, which is trading at Rs.70.
So the total premium we paid = 70+64 = 134.
The pay-off graph of this strategy is as follows-
By initiating this strategy, you are creating extreme bullish or extreme bearish bias. Your break-even points in this strategy will be Strike A – Debit paid and Strike B + Debit paid.
In our case, break-even points are 15965 on the lower side and 16634 on the upper side. In this strategy, the max profit is unlimited and the max loss will be the debit spread. Keep in mind that, to make a profit in this strategy, the index has to make the one side move in either direction otherwise, theta decay will put an extremely negative effect on this strategy.
Once you initiate this strategy, you want implied volatility to increase as a result there will be a potential rise in option prices and also there will be a potential move.
The Short Strangle strategy is the same as the long strangle, but instead of buying both out of the money option here, you sell both out of the money call & put options. You will make a profit from this strategy when the market goes sideways. Here the margin requirement is quite high, but with hedging, you can bring down the margin considerably.
However, the risk associated with this trade is quite high, but with hedging and further adjustments, you can mitigate that risk. While selling the strangle, it is better to sell options away from the spot price as their probability of becoming in the money decreases considerably. On the other hand, as you go away from the spot, the premium keeps on decreasing.
While selling this option, there should not be a skew in options. In simple words, the prices of both options should be close to each other.
Let’s consider nifty at 16300.
Step 1 – Sell OTM Call. In our case, let’s say we sell 16500 CE, which is trading at Rs.64.
Step 2 – Sell OTM Put. In our case, let’s say we sell 16100PE, which is trading at Rs.70.
The pay-off graph of short strangle is as follows-
So, the total premium we will get by selling these options is 134. By initiating this strategy, you are creating a sideways view on the markets. Your break-even points in this strategy will be Strike A – Credit Received and Strike B + Credit received. Max profit in this strategy will be the total credit received which is Rs.134 in our case. The risk in this trade is unlimited; however, it can be controlled by proper hedging. Implied Volatility should decrease after initiating this strategy as you want IV to cool off so that option prices will decrease.
Also, time decay has an extremely positive effect on this strategy as you want to take both sides’ premiums. In most cases, a short strangle strategy will make a profit because markets are sideways most of the time, but it is important to understand the risk associated with this trade. You should book your losses quickly and avoid big losses, especially when you are selling strangles without a hedge.
So, this was a brief explanation of the short strangle and long strangle strategies. I hope that through this article, you were able to understand the steps involved in initiating these strategies and when to use them.
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