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.)