If you’ve grasped the concept of a straddle, then it won’t be hard to understand the strangle. In essence, the reasoning behind both straddles and stranglers is comparable. Stranglers are basically an advancement of straddles, primarily to cut down on implementation costs. Allow me to provide further details.
Take this into account – Nifty is trading at 5921, so 5900 would constitute the ATM strike. This implies you’ll need to purchase 5900 CE and 5900 PE if you intend to employ the Long Straddle strategy. The premiums for each of these options are 66 and 57 respectively.
Net cash outlay = 66 + 57 = 123
Upper breakeven = 5921+123 = 6044
Lower breakeven = 5921 – 123 = 5798
Hence, spending 123 will provide you with a stable structure of the straddle, which is delta neutral and thus makes it immune to any directional shift of the market. This strategy is employed when one expects a substantial alteration in price levels, without anticipating the direction of change.
Based on your findings, you have invented a straddle which needs an initial payment of 123. It is intended to enable one to benefit from the movements in the market, whatever they might be.
What if you could establish a market-neutral approach, similar to straddle, but at much reduced expenses?
Well, the ‘Strangle’ does just that.
– Strategy Notes
The strangle is an improvisation of the straddle, which can help reduce strategy costs, yet increase the points needed to break even.
In a straddle you must purchase both call and put options of the ATM strike. On the other hand, with a strangle, you will purchase OTM call and put options which tend to be less expensive than an ATM strike. Therefore, implementing a strangle is typically more cost-effective than establishing a straddle.
Let’s take an example to explain this better –
Nifty is currently at 7921, so in order to set up a Strangle, we need to buy both call and put options that have the same expiration date and underlying asset. Make sure you execute them in the same ratio, which was missed when discussing straddle.
When considering a strangle (or straddle), one should buy the same number of call and put options. For example, 1:1 equates to buying one lot of calls and one lot of puts, whilst 5:5 would mean purchasing five lots for each. However, a ratio such as 2:3 is not indicative of a strangle or straddle where two lots on call options are bought and three on put options.
Considering Nifty is at 7921, it’s advisable to buy OTM Call and Put options. I’d go for strikes 200 points either way (this is just a suggestion). Therefore, I would purchase 7700 Put option and 8100 Call option, which are trading at 28 and 32 respectively.
We’ll take a look at how this ‘strangle’ behaves in a variety of conditions. I’m confident you can now accurately gauge the P&L in different market contexts. Let me summarise this quickly.
Scenario 1 – Market expires at 7500 (much below the PE strike)
At 7500, the call option will become worthless. However, the put option will have an intrinsic value of 200 points. The premium paid for this is 28, thus making the total profit from it +172.
We can deduct the premium of 32 paid for the call option from the 172 put option profits, resulting in a total profit of 140.
Scenario 2 – Market expires at 7640 (lower breakeven)
At 7640, the 7700 put option will possess an intrinsic value of 60. This compensates for the total premium paid on both options which is 32+28 = 60, thus meaning that no money is either earned or lost from the strangle at this point.
Scenario 3 – Market expires at 7700 (at PE strike)
At 7700, the call and put options would become worthless, so we would lose the total premium of 60 which is the maximum amount this strategy could cost us.
Scenario 4 – Market expires at 7900, 8100 (ATM and CE strike respectively)
Both the options will have expired worthless at 7900 and 8100, resulting in us losing all of the premium we paid – 60.
Scenarios 5 – Market expires at 8160 (upper breakeven)
At 8160, the 8100 call option has an intrinsic value of 60, which offsets the loss incurred from the premiums paid for the call and put options.
Scenarios 6 – Market expires at 8300 (much higher than the CE strike)
For the 8100 call option, its intrinsic value is 200 points, which presents a profit of 140 points after subtracting the premium paid of 60 points. It’s also worth noting that the payoff above and below the upper and lower breakeven points look similar.
We can generalize a few things about the ‘Strangle’ –
So as long as the market moves (irrespective of the direction) the profits are expected to follow.