The strategy is similar to long straddle where both contracts selected are usually at the money.
Let’s analyze the strategy with a live example of Nifty options. Today on 12th Jan 2017 , Nifty has closed at 8407. You are expecting a big movement in Nifty in coming few days. As per your expectation Nifty should cross 8500 resistance and move towards 8700. At the same time you fear that any negative news from abroad can pull down nifty towards 8000 levels. If you are looking to monetize from either of these situations then a long strangle is your perfect strategy.
In order to build your position you will,
- Buy Nifty 8400 CE at 12.
- Buy Nifty 8200 PE at 19.
Your total investment to construct your position is ( 12 + 19 ) x 75 = Rs. 2325.
Now let’s consider the following three scenarios at the time of expiry.
- Nifty has moved upwards and closed at 8550.
- 8400 CE will gain an intrinsic value of 150. You will gain profit of ( 150 – 12 ) x 75 = Rs. 10350.
- 8200 PE will expire worthless and you will loose the premium of Rs. 1425 (19 x75) to purchase it.
- Your net profit in the above position will be 10350 – 1425 = Rs. 8925.
- Nifty crashes to 8100 level on expiry.
- 8400 CE will have zero value and you loose Rs.900 ( 12 x 75 ).
- 8200 PE will go in the money and will gain a value of 100. You will square off it and keep the difference in premium ie ( 100 – 19 ) x 75 = Rs. 6075.
- Your total profit in this situation will be 6075 – 900 = Rs. 5175.
- Nifty expires at 8320 between both of your strike prices.
- Both options will expire worthless an and you will loose the total amount to purchase it which is Rs.2325.
From the last scenario it is clear that your total loss at any point is limited to the initial cash outflow to construct the position. Your profit potential is unlimited but required a huge movement in either direction to benefit most out of it. The cost involved into build your position is much less compared to straddle. But the time factor has a major role and there is a chance that both your option expire worthless in a flat market.
Do paper trades before applying any strategy to the live market. Hope this article helped you to master another trading strategy. Happy reading …