You would be bullish or bearish on specific sectors or stocks to gain the profits by taking an options position ahead of quarter results season and budget rally. Today, we are going to discuss one such options strategy which will make profits for you due to increase in volatility of particular stocks or index. This strategy is known as “Long Strangle” strategy. It allows you to take a bullish and bearish position at a same time on particular stock. This is one of the breakout option strategy in which an underlying security needs to go up or down to gain profits but price must not stay flat in the period of option
Concepts to Understand Long Strangle Strategy
Call Option and Put Option
Call Option gives its holder the right to buy a specified number of shares of the underlying stock at a predetermined price (strike price) between the date of purchase and the option’s expiration date
Put Option gives the holder the right to sell a specified number of shares of the underlying common stock at a predetermined price (strike price) on or before the expiration date of the contract.
The strike price is defined as the price at which the holder of an option can buy (in the case of a call option) or sell (in the case of a put option) the underlying security when the option is exercised.
A call option is out-of-the money when the strike price is higher than the market price of the underlying security.
A put option is out-of-the money when the strike price is below the market price of the underlying asset.
Constructing a Long Strangle position
To construct a long strangle position an investor is required to buy a certain number of out-of-the-money (OTM) call contracts in particular stock in a selected target month and buy same number of out-of-the-money put contracts for that month.
Example of Long Strangle Strategy
Meet Jinal Shah, an expert in options trading and not afraid to take high risks by analyzing the situation and performance of stocks. She’s had kept close watch on Infosys stock for quite some time, and expects the stock price will break out in the next few weeks, led by rupee depreciation against dollar and high expectations on third quarter results. The stock price has already gained ~4% in last nine trading sessions of January, 2012.
The share price of Infosys has moved from Rs 2804 to Rs 2890 and expected to break out in either direction after quarter results / rupee performance against dollar. With this in mind, Jinal opt to apply long strangle strategy in Infosys stock. Lets analyze, how Jinal plays with call option and put option
Construction of Long Strangle Strategy in Infosys stock
Assume, Infosys stock was trading at Rs 2800 when she entered the strategy. Then she buys 1 lot of Infosys January 2700 put option @ Rs 25 and buys 1 lot of Infosys January 2900 call option @ Rs 40. The lot size of Infosys stock is 125. The premium outflow in this strategy is Rs 65.
Computing Initial Outflow
Computing Breakeven Price
Profit and Loss Matrix
Jinal would profit from this strategy if the market price of Infosys goes above Rs 2,965 (upper breakeven price) or below Rs 2,635 (lower breakeven price). The profit could be unlimited when the price moves above upper breakeven and to the downside till the price reaches zero.
However, she could register losses if the price of Infosys closes between Rs 2,635 and Rs 2,965 at expiration. Her maximum loss could be reduced if Infosys closes between Rs 2700 and Rs 2900 at expiration.
Note: The costs of commission / brokerage are not considered in above computation.
Let’s examine different stock prices to draw a clear picture of the profit and loss matrix of this long strangle strategy
Assume the price of stock has declined
Assume the price of stock has increased
In above cases, Jinal did not execute her 2700 put option which expired worthless because it was out of the money put.
Advantages of Long Strangle Strategy
- You can gain from this strategy with price of underlying stock moving in either direction due to its price breakout characteristics.
- In high volatile stock, you can book profits on executing both options at proper timing by closing out either leg of the strategy prior to expiration.
Disadvantages of Long Strangle Strategy
- You are required to purchase two options so the initial costs are higher.
- The underlying stock performance is required to be greater in order to book profits from this strategy.
- Decline in volatility could cause greater losses since value of both calls and puts will drop