We’re all trying to look into the crystal stock market ball; will the bull market continue, allowing us to steam ahead to a level of 375-400, or will we see a sharp downward correction?
We tend to come across both scenarios in various analyses and articles. How can we exploit this?
Today we’re going to take a look at the Long Strangle for options investors. An option strategy that you can harness to make money either way.
The Long Strangle consists of two legs, the purchase of a Call option plus the purchase of a Put option with the same expiration date and a lower strike price. We’ll explain this strategy further by using an AEX Index case study.
The Long Strangle strongly resembles the Long Straddle. It is only the exercise price that sets them apart.
A Long Strangle can be used in a variety of different ways:
- You anticipate a substantial upwards or downwards movement in market price
- You expect a strong increase in volatility
For example, around an event, such as the Cyprus-euro. Before that event, you invest in a Long Strangle in the expectation that the price and / or the index volatility will react strongly.
A market movement must be so great that the increase in the value of one option is greater than the decrease in value of the other option.
If the volatility increases considerably, the value of both the Call and the Put option rise.
Don’t sit on a Long Strangle until expiration. The option premium reduces on a daily basis.
AEX-Index Case Study
The index is listed at EUR 354 (based on lunchtime prices on Wednesday, 20th March).
Suppose that you believe the price of the AEX-Index will move sharply in the next month, but you have no idea whether it will be a large increase or decrease in market price. You want to exploit a change of at least 5-10%.
The investment amounts to: the number of option contracts that you trade * contract size * (price of the purchased Call plus the price of the purchased Put).
Suppose that you buy one Call option AEX May-13 355 for 3.85 and you buy one Put option with the same expiration and a lower strike price 345 for 6.10. Then you’ll pay a balance of EUR 995 (= 1 * 100 * (3.85 + 6.10)).
Profit and Loss Chart
The graphical simulation for the Long Strangle looks like this:
The blue line indicates the theoretical profit as of today.
The orange line shows the return upon expiration.
If the market lists the price at between 345 and 355 upon expiration then you’ll realise the maximum loss using this strategy. The maximum loss amounts to your investment (-100%).
You can easily calculate the break-even points upon expiration on the back of a cigarette packet by taking the Put strike price minus the investment (345.00 - 9.95 = 335.05) and the call strike price plus the investment (355.00 + 9.95 = 364.95).
If the market price is less than 335.05 (-5.4%) or more than 364.95 (+3.1%) upon expiration then you’ll realise a profit using this strategy.
If the market price is 325.10 (-8.2%) or 374.90 (+5.9%) upon expiration then you’ll realise 100% profit using this strategy.
The maximum profit is unlimited, however, the statistical chance of this is small.
The disadvantage of the Long Strangle is that small market movements will result in daily monetary losses on your position. This is due to the Theta. You can predict the amount of this loss in advance. The graph reveals that this will cost 12 euros per day.
This amount will increase as the maturity decreases.
A second disadvantage is that if the volatility decreases, the value of the option premiums will also drop.
Take particular care around events. Don’t open a Long Strangle when volatility is too high. In the run-up to an event, volatility increases. Buying a Long Strangle too late comes with the disadvantage that if there is a large movement in market price then the profit will often be offset. This is because volatility decreases substantially after the event and the option premiums collapse.
The advantage of the Long Strangle is that you can make money either way. Both a large market price increase and a substantial market price decrease can be profitable. ‘So long as something happens’.
In addition, you get to benefit from higher volatility. Market turmoil causes an increase in volatility, resulting in higher option premiums.
The graph below shows the impact of volatility:
At the current market rate, the Vega Position is now more than 107 euros.
This means that if volatility increases by 1 percentage point, the value of the Long Strangle increases (in your favour) by 107 euros. At an investment of EUR 995.
The AEX Implied Volatility Index records 11.6%. The Percentile is 5%. The Volatility is historically low. A positive sign for a long premium position.
Some of the pitfalls associated with a Long Strangle are:
- Opening at too high a price; buying at too high a Volatility.
- Taking the profit too quickly
- Sitting on the position too long without profit
Please note that this example is for illustration and education purposes only and does not incorporate transaction costs. This example is not a recommendation.
Herbert Robijn is founder and director of FINODEX (www.finodex.com). FINODEX develops innovative online investment tools for private equity and options investors. These cutting-edge tools allow investors to make a comprehensive market analysis, complex calculations and appropriate selections, at just the touch of a button.
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