The market was ripe for strangles; it probably still is…
First let me enlighten what I am referring to by a strangle. In options trading, when you are not sure of the market direction, you can buy a call option as well as a put option. The result will be that you make money, no matter the markets go up or down. So, a Strangle is that simple really?
Not exactly that simple, though…
A strangle involves buying a higher call option and a lower put option at the same time. If the stock goes up you make money on the call; if the stock goes down you make money on the put.
However, it is not that simple in practice. As a trader, you need to cover the total cost of the call and the put to make money. So if you bought a Reliance 940 Call @ Rs.20 and Reliance 900 Put @ Rs.10, then you will make money if Reliance goes above Rs.960 or below Rs.890. So you need time and volatility in your favor; after all when you buy an option the time works against you. It is this range that makes strangles rarely profitable.
Buy why strangles, now?
Over the last 3 weeks, you could have made money on strangles in most of the stocks. The reason was simple. The volatility in the market was gradually going up. So you could have managed to buy call and put options at lower prices and then got the volatility to compensate you for the loss of time value. The question is, why now?
We have been in a market where individual sectors and stocks have been richly valued. At the same time you had liquidity inflows keeping valuations buoyant. As doubts are voiced on the India story, strangles start making sense. Typically, the call option gives you protection against liquidity inflows while the put option gives you protection against valuation concerns. Let me explain how it works in practice!
How specific strangles worked
Over the last 3 weeks, strangles on most stocks would have worked to perfection. Be it Infosys, TCS, Lupin, Sun Pharma, IndusInd Bank or even Axis Bank, your strangles would have made enough money to cover your total cost. Buying merely a call or a put may have entailed too much of a directional risk. The moral of the story is that it is specific occasions like these when volatility is rising to compensate for loss of time value that strangles work perfectly to make profits for you
That brings me to the key question; can we still look at strangles at this juncture? Unfortunately, these strangles may not be as profitable as they have been in the last one month. After a correction of 10%, buying puts may not be too smart in a bull market. Buying calls may be your best bet! ©