A Step-by-Step Guide
How to Buy a Long Strangle
Introduction to Long Strangle Strategy
How to Buy a Long Strangle ?
A long strangle is an options trading strategy used to profit from significant price movements in either direction—up or down. It involves buying both a call option and a put option with the same expiry date but different strike prices. The call option has a strike price higher than the current stock price, while the put option has a strike price lower than the current stock price.
Traders use the long strangle when they anticipate high volatility in the underlying asset but are uncertain about the direction of the price movement. The strategy works well during events such as earnings announcements, regulatory decisions, or economic reports.
Step-by-Step Guide to Buying a Long Strangle
Step 1: Select the Right Stock
Choosing a stock with a history of volatility or an upcoming event that could lead to significant price movement is crucial. For this example, let’s consider Reliance Industries Limited (RIL), one of India’s largest and most actively traded stocks.
Step 2: Choose an Expiry Date
Options contracts have different expiry dates. For our example, assume we are selecting options expiring in the next monthly expiry cycle.
Step 3: Select Strike Prices
For a long strangle, choose:
- Call Option: A strike price above the current market price.
- Put Option: A strike price below the current market price.
Assume RIL is currently trading at ₹2,500 per share. A trader could select:
- Call Option: Strike Price ₹2,600
- Put Option: Strike Price ₹2,400
Step 4: Buy the Call and Put Options
To execute the long strangle, you need to:
- Buy a Call Option with a strike price of ₹2,600.
- Buy a Put Option with a strike price of ₹2,400.
Let’s assume the premium for the call option is ₹30, and the premium for the put option is ₹35. The total cost per share would be:
Total Premium Paid = ₹30 (Call) + ₹35 (Put) = ₹65 per share
Since options contracts have a lot size of 500 shares for RIL, the total investment would be:
Total Cost = ₹65 × 500 = ₹32,500
Step 5: Monitor the Market Movement
The long strangle strategy will be profitable if RIL’s stock price moves significantly in either direction before expiry.
- If RIL’s price rises sharply above ₹2,600, the call option gains value.
- If RIL’s price falls sharply below ₹2,400, the put option gains value.
Since the maximum risk is limited to the premium paid (₹32,500), traders need a strong price movement beyond the breakeven points to turn a profit.
Step 6: Determine the Breakeven Points
To calculate the breakeven prices:
- Upper Breakeven Point = Strike Price of Call + Total Premium Paid = ₹2,600 + ₹65 = ₹2,665
- Lower Breakeven Point = Strike Price of Put – Total Premium Paid = ₹2,400 – ₹65 = ₹2,335
For the trade to be profitable, RIL’s stock price must move beyond either ₹2,665 (upside) or ₹2,335 (downside) before expiry.
Step 7: Exit the Trade
Traders can exit the position when:
- The price moves beyond the breakeven points, yielding profits.
- Volatility drops, causing premiums to erode, signaling a need to cut losses.
- Before expiry, if the trade is profitable, to avoid time decay effects.
Pros and Cons of the Long Strangle Strategy
Pros:
- Limited Risk: Maximum loss is limited to the premium paid.
- Unlimited Profit Potential: If the stock moves significantly in either direction, profits can be substantial.
- Flexibility: The strategy does not require guessing the direction of movement, only that a large move will occur.
Cons:
- Time Decay: As expiry approaches, options lose value if the stock doesn’t move significantly.
- Higher Cost: Buying two options means a higher upfront cost.
- Liquidity and Slippage: Wide bid-ask spreads in some options can increase costs.
Conclusion
A long strangle is a great strategy for traders expecting significant price swings in a stock like Reliance Industries but uncertain about the direction. While the risk is limited to the initial premium paid, a strong price movement is necessary for profitability. Traders should monitor volatility, time decay, and exit points to optimize returns from this strategy. By following this guide, traders can effectively implement a long strangle strategy and potentially benefit from large price movements.
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