Understanding The Long Strangle Strategy

As against the Long Straddle strategy, how does the Long Strangle strategy work? In what ways can it benefit a trader? The article puts into the spotlight this particular approach to investing 

In the realm of equity derivatives, option strategies offer a spectrum of opportunities for traders. While we have discussed some such strategies in our previous issue such as Long Straddle for those expecting significant market movement in either direction, the Long Strangle presents a slightly different approach. This strategy is crafted for traders who anticipate a significant move but want to reduce their initial cost. Let’s dive into this strategy with the help of a fictional trader called Sarvani Shah and compare it with the Long Straddle.

Sarvani, a thoughtful and curious trader from Hyderabad, has been trading in the stock market for a few years. She has always sought to learn new strategies to improve her trading performance. After reading about the Long Straddle strategy in our first issue, Sarvani was intrigued. However, she felt the need for a strategy that offered similar benefits but with a lower initial cost.

One evening, while discussing her trading experiences with her friend Rishi Raj, whom we met in the previous issue, Sarvani learned about the Long Strangle strategy. Rishi explained how the Long Strangle could be a more cost-effective way to benefit from large market moves, even if the direction was unclear. Excited by this new knowledge, Sarvani decided to dive deeper.

Long Straddle versus. Long Strangle: Key Differences

Long Straddle
▪ Objective: To profit from significant price movements in either direction.
▪ Components: Buying one at-the-money (ATM) call and one ATM put option.
▪ Market Outlook: Anticipates high volatility and substantial price changes.
▪ Risk and Reward: Unlimited profit potential if the market moves sharply in either direction. The maximum loss is limited to the total premium paid for the options.

Long Strangle 
▪ Objective: To profit from significant price movements in either direction, but with a lower initial cost. 
▪ Components: Buying one slightly out-of-the-money (OTM) call and one slightly OTM put option. 
▪ Market Outlook: Expects high volatility with a significant price move but is more cost-conscious. 
▪ Risk and Reward: Lower initial cost compared to the Long Straddle, but with higher breakeven points. Profit potential is still substantial, though slightly lower than the Long Straddle due    to the OTM options.

Understanding the Long Strangle Strategy
The Long Strangle strategy is a variation of the Long Straddle, designed for traders like Sarvani who are looking to profit from large market moves without paying the higher premiums associated with ATM options. This strategy involves buying an slightlyOTM call and an slightly OTM put option, both with the same expiry date.

Example:
Given the following conditions:
Nifty Current Market Price: ₹24,500
OTM Strike 24,600 CE Price: ₹95
OTM Strike 24,400 PE Price: ₹92
Expiry Date: August 29, 2024

To execute the Long Strangle strategy, Sarvani would purchase the 24,600 strike call and the 24,400 strike put options. Here’s what happens:
Call Option: Buys the right to purchase Nifty at ₹24,600.
Put Option: Buys the right to sell Nifty at ₹24,400.

Breakeven Points
The Long Strangle strategy has two breakeven points, beyond which the position will start delivering profits after accounting for the total premiums paid.

1. Upper Breakeven Point: 24,600 + (95 + 92) = ₹24,787
2. Lower Breakeven Point: 24,400 − (95 + 92) = ₹24,213

This means Sarvani’s position will be profitable if Nifty moves beyond 24,787 on the upside or below 24,213 on the downside. If Nifty remains between these levels, her maximum loss will be the total premium paid, which is ₹187.

Payoff Structure
The payoff for the Long Strangle strategy depends on the price of the underlying asset at expiry. Let’s break it down:

1. At Expiry:
If the Nifty price is much higher than 24,600:
a) The call option will be in the money, resulting in a profit.
b) The put option will expire worthless, resulting in a loss.
c) Net Payoff: Call option profit - Put option premium paid.

If the Nifty price is much lower than 24,400:
a) The put option will be in the money, resulting in a profit.
b) The call option will expire worthless, resulting in a loss.
c) Net Payoff: Put option profit - Call option premium paid.

If the Nifty price is between 24,600 and 24,400:
a) Both options may expire worthless or have very low intrinsic value.
b) Net Payoff: -(Call option premium paid + Put option premium paid). The following table and diagram will help in understanding the payoff:

Position Management for Long Strangle
▪ Profit Zone: Once Nifty moves beyond the breakeven point zone (either above ₹24,787 or below ₹24,213), the position will start showing profits. The farther Nifty moves from the breakeven points, the higher the potential profits.

▪ Loss Zone: If Nifty remains within the breakeven zone (₹24,213 to ₹24,787), the position will incur losses. The maximum loss occurs if Nifty closes between the two strike prices, where both options may expire worthless, resulting in the total premium paid being the loss.

▪ Exit Strategy: If the targets of the position are not met and the underlying remains in the breakeven zone, it is advisable to exit the position by the last Friday of the expiry. This is because the premium decay accelerates as expiry approaches, which can erode the value of the position rapidly.

By carefully monitoring the Nifty levels and the breakeven zone, Sarvani can manage her Long Strangle position effectively to maximise profits or minimise losses.

Conclusion
The long strangle strategy involves buying a call option and a put option at different strike prices, slightly out-of-the-money (OTM). This strategy is ideal when you expect significant volatility in the market. Choosing slightly OTM strikes is crucial because it balances the cost and the probability of making a profit. If you pick far OTM strikes, the cost might be lower, but the likelihood of the market reaching those levels and yielding a profit decreases.

The strategy becomes profitable if the underlying asset’s price moves beyond the breakeven points. However, if the price remains within the breakeven zone, the strategy results in a loss. Exiting near the expiry is essential to avoid the rapid decay of option premiums. With careful strike selection and timing, traders can use the long strangle to benefit from anticipated market movements.