There are several strategies in options trading for both option buyers and sellers. There are strategies which are specific to particular market moves. There are two most common and famous strategies one is strangle, and another is straddle (both short and long). In this article, I will explain the most popular strategy called Strangle.
What is Strangle Strategy?
In this strategy, we sell deep out of the money options. We will sell one put option and one call option of the same expiry. We will sell both the contracts at a suitable gap from at the money option. For example, if USDINR is trading at 74.80 (as on Aug 12, 2020). We will be selling August or September month expiry (depending on your risk appetite). For our purpose let us sell September month expiry contracts (because already half of the august month is gone).
So the strangle strategy would be to sell ten lots each of 77 strike call, and 73.75 strike put.
Here is the premium detail for 77 call
10 X 0.79 X 1000 = Rs. 7900
Here is the premium detail for 73.75 put
10 X 0.2125 X 1000 = Rs 2125
Total premium collection = Rs 10,025
strangle strategy and payoff graph
I am using an online payoff graph tool, so the premium price could be wrong. But that is not the point, point is to explain the strategy and its pros and cons.
Which type of trader uses this strategy?
This strategy is deployed by option sellers and conservative traders.
Which type of market is suitable for this strategy?
This strategy works best when markets are range bound.
When this strategy would fail?
This strategy will fail when market is trending. In that scenario it is preferable to sell naked options in the opposite of the market or buy an option in the direction of the trend.
What is the maximum profit in this Strategy?
The net premium collected from the sell of both put and call option is the maximum profit in this strategy
What is the maximum loss?
The loss is infinite if the market starts to trend.
How maximum loss can be minimized?
There are two ways to reduce or minimize the loss in this strategy:
- Put a stop-loss
- Buy insurance premiums to protect the strategy. Here the option strategy could be hedged by buying the next strike put and next strike call. In our case will buy strike 73.5 put and strike 77.25 call to protect and hedge our risk.
What is the drawback of putting a stop-loss in option selling strategy?
First of all, if you are an intraday trader, then option selling in currency might not be a fruitful and rewarding job. If you plan to sell options, then selling it for a monthly expiry or weekly expiry can yield some results. However, unlike western economies, where markets are more developed, Indian markets are yet to become mature. We are still far behind our western counterparts. The system and the market timings both are of critical importance to a trader. In India, all the brokers will keep stop-loss order until the market ends. So basically stop-loss works fine during the intraday situations. You can place AMO to minimize risk for overnight positions. But unlike the stock market, currency markets are 24X7 operations, so expect a gap up or down when the exchanges open the currency derivative markets. So at night markets would be moving against our opinion and we won’t be able to do much except placing an AMO for stopping out the loss. If the market gaps up or gaps down against our wishes, then stop loss will fail.
Why buying options is much more preferred than putting a stop loss?
Buying options act like buying insurance for business operation. The magic is that you don’t need to pay anything to buy the premiums. The premium is paid from the sell of the options. In this methodology, you have to buy premium of immediate next strike price., i.e., we will buy 73.5 put and 77.25 calls. Once we buy insurance for our strategy, the payoff graph would look like as shown here
payoff graph after buying immediate options Will buying insurance safeguard my strategy 100%?
I would say no, you buy insurance against any event leading to your death, but still, you believe that you won’t die too early. Does insurance help you to avoid accidental death? No, but it gives you peace of mind that in the event of any such circumstance, your family would be safe. The opinion with which you had deployed strategy has changed, and the market is trending. Since the idea of option selling is to sell far deep out of the money options, in the event of a strong trend or event, this strategy would fail as explained. So better is to exit at that point and change the strategy.
Should you use Technical analysis along with this strategy?
It is a personal call. If you are comfortable to use only option chain data, then you perhaps don’t require Technical analysis. However, I prefer to use Technical analysis along with the option chain to derive my opinion regarding the currency pairs movement. In one of my post I have explained, using Donchian channels, I made 45% return in my portfolio. I prefer to use this indicator along with this strategy. This is a very conservative strategy and the returns are very low and carry very low risk.
When should you exit?
The exit timing is also an essential point of discussion. Now suppose the currency pairs have started to trend but near the expiry. In that situation, it has been observed that current month options decay and volatility in the current month contracts reduce. The reason is simple people start to roll over to next month contracts where volume and volatility both are high. Still occasionally if the currency pair is trading with very high volatility due to some event like terrorist attacks, in that situation it is always better to exit and book some loss. However, in normal market conditions, even if pairs start to trend, then there is a slight chance that trade setup would incur significant losses. On the contrary, if the strike price is in the money, the premiums would have decayed to a reasonable value. And you may be allowed to keep most of the premium.
But in my experience, since the day I have started trading in currency options, I have rarely found the markets trending for very longer period of time. At some point of time banks would be intervening or would be constantly intervening to cool off the trend and thus currency markets would be range bound most of the time with smaller smaller trends. You can read more about banks acting as market operators in my post. At the same time, it cannot be denied that in future we may not experience strong trends continuing for months. It is quite possible that currency pairs could move more than 20% in a single trading session as explained in the post here. So in these types of situations one’s own judgement and experience comes to rescue.
In the end I would say always protect your capital and don’t be too much greedy.
Any comment, suggestion or feedback is welcome.