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Option Strategies-2
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To Read the first Blog (Introduction to options) in this Series Click here

To Read the Second Blog (Working of Options) in this Series Click here.

To Read the Third Blog (Option Strategie) in this Series Click here.

We earlier discussed straddle as as option strategy. Let us today discuss another option strategy called Strangle. It is another frequently used strategy of options trading.

The long strangle or buy strangle involves the simultaneous buying of a slightly out-of-the-money (OTM) put and a slightly out-of-the-money (OTM) call of the same underlying stock and expiration date but different strike prices.

The long options strangle is an unlimited profit, limited risk strategy undertaken with a view that the underlying stock will experience significant volatility in the near term. Maximum loss in case of a long strangle options strategy arises when the spot price of the underlying on expiration date is between the strike prices of the options bought. At this price, both the options expire worthless and the options trader loses the premium that he paid for buying the options.

Let us take an example. Suppose a stock Z is trading at Rs 90 per share currently. An options trader buys a put option at a strike price of Rs 84 for Rs 3 and a call option at a strike price of Rs 96 for Rs 3, where the expiry dates for both the options are same (say, one month from now). So the entire debit taken to enter the trade is Rs 6 (Rs 3 + Rs 3).

If the share price rises to Rs 104 on expiration date, the put option will be left to lapse as the trader is better off selling in the market at Rs 104 instead. But, there will be a net profit of Rs 104-96-6 = Rs 2.

If, on expiration, the share price is Rs 90 only, both the call and put options will expire worthless, and the trader will suffer a maximum loss of Rs 6, which is the price of buying the options. The payoff at different spot prices for the long strangle is shown in the chart below:

Option Strategies 

Long Strangle

The short strangle, also known as sell strangle, is a strategy that involves the simultaneous selling of a slightly out-of-the-money put and a slightly out-of-the-money call of the same underlying stock and expiration date but different strike prices.

The short strangle option strategy is a limited profit, unlimited risk strategy that is taken when the options trader thinks that the underlying stock will experience little volatility in the near term.

Maximum profit for the short strangle occurs when the underlying stock price on expiration date is trading between the strike prices of the options sold. At this price, both options expire worthless and the options trader gets to keep the options premium.

Suppose a stock is trading at Rs 90 per share currently. An options trader sells a put option at a strike price of Rs 84 for Rs 3 and a call option at a strike price of Rs 96 for Rs 3, where the expiry dates for both the options are same (say, one month from now).

If the share price rises to Rs 104 on expiration date, the put option will be left to expire worthless and the call option will be exercised. But there will be a net loss of Rs 2 for the option writer.

If, on expiration, the share price is Rs 90 only, both the call and put options will expire worthless and the option seller will get to keep the option premiums i.e., Rs 6.

The payoff at different spot prices for the short strangle is shown in the chart below:

 Option Strategies

Short Strangle

References:

Rustagi, Dr. R.P., Investment Management: Theory and Practice (2008)

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