As markets get increasingly volatile, it is time to buy strangles…

Over the last 4 weeks we have seen the market volatility go up sharply as global uncertainty has increased. This is evident from the sharp rise in the NSE VIX which had crossed 20 before settling at around the 18 mark. But it is still highly susceptible to sharp spikes. In this kind of a market, trading either on the short side or the long side can be fraught with risks. It is highly likely that even when your view is right, the stop losses may get hit before your targets are realized. So how should one approach this kind of market and what should be the ideal strategy for this market?

The answer to this question may lie in playing on volatility. For example when you know that a particular stock is likely to break out sharply but you are not sure whether it will be on the upside or the downside, what do you do? The answer could lie in creating a strangle strategy. You can do this by simultaneously buying a call and a put option on the same stock. Let us understand the strategy a little better…

What is a strangle strategy all about…

As suggested earlier, a strangle strategy is when you buy a call and put option on the same stock or index. For example assume that the current price of Maruti is Rs.3750. You are fairly clear that Maruti will have an upside breakout. But considering the volatility in the market, you also want to protect yourself in case the stock moves down due to negative auto sector cues. The answer is you buy a put and a call on the stock. In this case, you can buy a Maruti 3800 call and a Maruti 3700 put. Assume that the call is quoting at Rs.70 and the put is quoting at Rs.60. Therefore the total cost of your strategy will be Rs.130. Technically you will be profitable if either Maruti moves above 3930 or moves below 3570. At that price the entire cost of the strategy gets covered and you start to make a profit.

But in reality you play for volatility not for price…

The above example of Maruti is very straightforward and simplistic. You in fact play for increase in volatility and not for the price movement. Let us understand how it works. When Maruti is quoting at Rs.3750, then both the 3700 put and the 3800 call are out of the money. That means the entire premium is only time value and there is no intrinsic value in these options. During the period let us assume that the volatility shoots up sharply from 18 to 24 on the NSE VIX. Assuming that the Maruti stock continues to quote in the range of 3700-3800, the increased volatility will take the time value of both the options much higher. Thus the trader can get out at a neat profit and make money without worrying about estimating whether the Maruti stock will go up or down.

Why strangles now?

That brings us to the next question, why strangles now? The answer lies in the current global economic scenario. Firstly, the worries over China and cheap oil are far from over. The volatility has been subdued to around the 18 levels and any global news flow is likely to take the volatility much higher. That is what we can benefit through strangles. We do not worry about whether Maruti goes up or down. We purely focus on the assumption that the volatility in Maruti will go up and nothing else.

Remember, in normal markets it is very difficult to make money through strangles. You make money on strangles only on two occasions. Firstly, when you expect that the market is going to turn from a lacklustre market to a volatile market. That is a slightly difficult and risky call to take. Secondly, there are times like the current scenario wherein the volatility has come down sharply but the risk factors remain. In that case, you bet on a spike in volatility, which is a less risky thing to do. That is why strangle strategies are making a lot of sense now.

But how to identify strangles in practice…

Focus on stocks that have outperformed their sectors. In a volatile market, these are the most likely to benefit from volatility. Secondly, look for stocks that have trying to break out but have not succeeded in the same. These are the kind of stocks that are most likely to react to a spike in volatility.

Do remember that creating a strangle strategy is not just about identifying stocks. You also need to identify pricing. You also need to find out if the options are underpriced, fairly priced or overpriced. Most trading software offer this facility and it is fairly simple to use. It is better you consult your broker or advisor who can also advise you on the right methodology of going ahead. But the time is ripe. Strangles, if designed properly, can make money with minimal risks in this kind of a market.

You can ask us your stock related questions with #AskReligareOnMarkets via our Twitter channel @religareonline

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