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Wednesday, June 15, 2011

How to Short Strangle a sideways market – a guest post

In last month’s guest post, Nishit explained how options can be used to hedge your stock portfolio against potential losses. It can be a useful tool, provided you learn how to use it properly. The added advantage is that you need not sell off your holdings, if you are properly hedged.

What happens when a stock market is not going anywhere? Taking two steps forward and three steps back? Nishit presents a neat strategy that can make money in a sideways market. If you like what you read, or have a question, please leave a comment for Nishit.

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The markets are trading sideways for the past several days. How do Option Writers benefit from this?

As explained last month, Options are perishable commodities. They are a factor of price value and time value. For example, if Nifty is at 5550 and 5500 Call Option is trading at 110 rupees, 50 rupees is the intrinsic value and 60 rupees is the time value. Time value is value of time left till expiry when the Option will be squared off at the market price. The extra premium is with the expectation that the price will move up by at least 60 rupees till expiry.

Introduction on Options as below:

http://money-manthan.blogspot.com/2010/12/introduction-to-options-part-1.html

Options are bought by people and those people who sell Options are known as Option Writers. Why would people write options? Option Writers always make the maximum money and they are often big institutions.

In a sideways market, one can have a Short Strangle. What does this mean? The Nifty is now near 5400 and trading in a band between 5350 and 5600. The days to expiry are 2 weeks. One can write the 5300 put at say 60 rupees and 5600 call at 50 rupees. By writing these 2 Options we can get 110 rupees as premium.

Can we make a loss?

If the Nifty goes below 5300 or above 5600 we start making losses, in the sense that we will have to pay out money at expiry. We had received 110 rupees as premium so theoretically we are safe between 5190 to 5710. At the most we will make no loss and no profit.

Also, once the direction becomes clear we can either short Nifty or buy Nifty to cover the direction whether we are making a loss. Thus one side we take in the entire amount as profit.

Writing of Options should be done keeping the technical levels in mind and not in isolation.

One more way of deploying cash balance is at the end of the month. About 4 - 5 days from expiry, write Calls about 200 points above current market price. The price of each Call would be about 10 rupees after removing the brokerage.

Now, a margin of 1 lakh will allow you to write 4 lots which will bring in about 2000 rupees. Doing it every month for 12 months, will bring you 24000 or about 24% return on capital deployed.

The Caveat Emptor here is that one should keep technicals in mind and not blindly write calls. Also, calls are much safer to write than puts as sharp rise in price is never sudden as against a sharp fall due to news events.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)

4 comments:

Ganpat said...

Thanks for the post Nishit but what you say is known to many and so Call options are always going cheap.
You say to write four lots of CE 4 days before expiry for 200 points plus spot at 10 net.
If you see todays closing price of 5600CE 200 points above spot is available at 15 excluding brokerage, and we have a full 15 days for the expiry!!
Needless to say to write them at that price is SUICIDAL
Now coming to the strangle part which says..
The Nifty is now near 5400 and trading in a band between 5350 and 5600. The days to expiry are 2 weeks. One can write the 5300 put at say 60 rupees and 5600 call at 50 rupees. By writing these 2 Options we can get 110 rupees as premium...

Dear Sir,I would like to sell at this rate and could you pl find a
buyer for me? LOL
Yesterday closing price
5600CE:Rs 23
5300PE:Rs 29

Thanks and no offense meant pl.

Nishit Vadhavkar said...

Thanks Ganpat for your post. Its obvious what I have written is known to me, its not Rocket Science.
My idea is to share this with those who dont know.
Why not wait for 4 days till expiry and see the appropriate option strike price. I have done it for the 2 months and hence I am writing so.
The prices I took are just indicative and I hadnt referred this month's option strike prices. The prices are always a measure of VIX.
Maybe you could write some strategies for trading.

Ganpat said...

Thank you Nishit for your clarifications

But when I had a cursory look in the last few months I didn't find any 200points plus spot CE SP going at 12+.Kindly give some more details.

If your rule is modifies as..

"IF" you find in the last 4 days of expiry,the premium of CE SP of 200 points plus the spot going at a premium of 12+,then sell four lots for a profit of abt 40 points at the expiry..

then none can question that..
But the "IF" part makes all the difference!

Thanks

Nishit Vadhavkar said...

I checked my trade Ganpat. I had written 5700 May CE at 8 rupees on the day when Nifty closed at 5438.

So almost 260 points away I got it for 8 bucks.The catch is I wrote it 6 days away from expiry.

What I have given is an illustrative example and you can tweak it somewhat.

I find this nitpicking attitude of yours completely counter productive. The whole idea is to pick up an idea and refine it.

No offense meant.