Understanding the straddle will make it easy to understand the 'Strangle. The thought process behind strangle and straddle is very similar. Strangle is an improvement on the straddle to lower the cost of implementation. Let me tell you more.
This is a good example: Nifty trades at 5921. That would make 5900 the ATM strike. To set up the long-straddle, you would need to purchase the 5900 CE or 5900 PE. These options have premiums of 66 and 57, respectively.
Net cash outlay = = 66 +57 = 123
Lower breakeven = 5921+123 = 60044
Lower breakeven = 592 - 123 = 59798
To set up a straddle you will need to spend 123. The breakeven for either side is therefore 2.07%. The straddle is also delta neutral. This means that it is immune to market direction. This means that although you are aware that the market will move in a significant way, the direction of the market is not known.
This is what you should think about: You know the direction of the market (direction unknown) and have therefore set up the straddle. The straddle will require you to pay 123 upfront
What would your market neutral strategy look like?
The 'Strangle does exactly that.
The strangle is an improvisation of the straddle. While the improvisation helps reduce the strategy cost, it also increases the point required to breakeven.
You must buy options and call options for the ATM strike in order to purchase a straddle. The strangle however requires that you buy OTM call options and put options. Compared to the ATM strike, the OTM trades at a discount so it can be more affordable than setting up one.
Let's look at an example to illustrate this better.
Nifty trades at 7921. To create a strangle, we must buy OTM call and put options. Both options must have the same expiry as the same underlying. Execution should also occur in the same proportion (missed this point when discussing straddle).
The same ratio means that one should purchase the same amount of call options as put options. It could be a 1:1 ratio, meaning one lot of call and one lot of put option. It can also be 5:5, which means you buy 5 lots each of call options and 5 put option. Strangle (or straddle), a ratio of 2:3 does not apply. In this case, you would buy 2 lots of call options as well as 3 lots of put options.
We need to purchase OTM Call and Put options, as Nifty is currently at 7921. I prefer to purchase strikes that are 200 points each way. (Note, there's no reason to choose strikes 200 points away). This would be 7700 Call option and 8100 Put option. These options trade at 28 and 32, respectively.
60 is the combined premium for execution of the'strangle. Let's see how strategies perform under different scenarios. As I believe you're now comfortable accessing your P&L in different market scenarios, I will keep this brief.
Scenario 1: Market closes at 7500 (much lower than the PE strike).
The premium for the call option, i.e. 7500, is deducted from the premium. 32 will be worthless. The intrinsic value of the put option is 200 points. Therefore, the premium for the Put option is 28. The total profit from this option will be 200 - +172
Further, we can deduct the premium for the call option (i.e. 32 can be deducted from the profits of the Put option to arrive at the overall profitability, i.e. 172 - 32 = +140
Scenario 2: Market closes at 7640 (lower breakeven).
The 7700 put option, which costs 7640, will have an intrinsic price of 60. The intrinsic value of the put option is less than the premium that was paid for both the call option and the put option. 32+28 = 60. Therefore, at 7640, the strangle does not make money or lose money.
Scenario 3 Market closes at 7700 (at PE Strike)
Both the put and call options would cease to be valid at 7700. We would therefore lose all premiums paid. 32 + 28 = 60. This is also the maximum loss that the strategy could sustain.
Scenario 4: Market closes at 7900 and 8100 (ATM strike and CE strike respectively).
Both options become worthless at 7900 or 8100. We would then lose all premiums paid, i.e. 60
Scenario 5- market expire at 8160
The 8100 Call option at 8160 has an intrinsic value 60. Therefore, the gains from the call option would compensate for the loss in premiums paid towards call and put options.
Scenarios 6 Market closes at 8300 (much earlier than the CE strike).
The 8300 call option would have an intrinsic worth of 200 points at 8300. Therefore, the option would be worth 200 points. After accounting for 60 points of premium, 140 points profit would be available. You can see the symmetry in the payoff between the higher and lower breakeven points.
Below is a table that shows various market expiry scenarios as well as the potential payoff at these levels.
To visualize the payoff diagram for the strangle, we can plot the strategy payoff.
A few general observations can be made about the "Strangle" -
Profits can be expected to follow the market's movements, regardless of its direction.
Because strangles and straddles are both similar strategies, the Greeks have an identical effect on strangles and straddles.
OTM options are being discussed. We chose strikes that were equidistant to ATM so the delta of CE and PE would be approximately 0.3 or less. You could also add the deltas for each option to get an idea of the overall behavior of the position deltas.
For convenience, I assumed 0.3 for each option. However, both deltas could be slightly different so we cannot be considered delta neutral. The combined deltas won't be so high that they create a directional bias in the strategy. However, the combined delta shows that the strategy does not have a directional bias.
Both strangles and straddles are affected by volatility in a similar way.
The effect of Greeks upon strangles can be summarized as follows:
You probably understand why strangles must be established around major market events. We have already discussed this point. If you're still unsure, I suggest you read Chapter 10.
The short strangle's execution is opposite to long strangle. OTM Call and Put options must be sold that are equal to the ATM strike. You would actually shorten the'strangle for exactly the opposite reason why you go long strangle. As I presume you are comfortable with the payoff, I won't discuss the different expiry scenarios.
The same strikes I used for the long strangle example have been used for the short strangle. These options can be purchased, but you could also sell them to create a short strangle. The payoff table for the short strangle is shown below.
The strategy is a losing strategy as the market moves in any given direction. The strategy is profitable at both the lower and higher breakeven points. Remember -
This means that you can take home 60 points provided the market remains within 7640-8160. This is my view, a great deal. Markets tend to stay within certain trading ranges, which makes it a great place for trading.
Here's something to think about: Identify stocks that are within a trading range. Stocks in a range typically have double/triple tops or bottoms. You can set up the "strangle" by writing strikes that are not within the upper or lower range. Watch out for any breakouts or breakdowns when you are writing strangles against this background.
This trade was set up in Reliance a few years back. Reliance was between 850-1000 for the longest time.
Here is the payoff graph for the short strangle.
You can see -
The calculation of the breakeven point is the same as that for a long strangle, as we discussed earlier.