Why short strangles can be risky?

Guide to Technical Research | Published on 31st July 2018 | 690

If you have been in the derivatives market for some time, you would have surely heard the now famous story of how Nick Leeson brought down Barings Bank of London. Leeson, who was heading the Barings trading desk out of Singapore, had heavily sold strangles on the Nikkei (Japanese index). Essentially, he had sold higher call options and lower put options. The logic of the trade was that the Nikkei would remain in a narrow range and therefore Barings will be able to pocket the premiums on the call and the put option. Unfortunately, things went haywire when Kobe was struck by an earthquake in 1995. The Nikkei tumbled the next day and the losses just became unmanageable for Leeson. Even as Leeson tried to escape to Europe, Barings saw its entire capital being wiped out. That is how risky short strangles can be. Obviously, we also need to understand as to why short strangles is risky? Let us begin with a basic understand of what a shot strangle is all about?

Structuring a short strangle strategy in options

How to trade the futures and options when the markets are bullish or bearish is fairly simple. But how do you trade the market when either it is volatile or range-bound. Effectively, there is no direction. Obviously, a directional view will not work in this case. The answer could lie in volatile strategies. Two of the most popular volatile strategies often used are straddles and strangles. In a strangle you buy higher calls and buy lower puts. But, this will work when your view is that the markets will be volatile. What if your view is that the market will be stuck in a range? The answer is that instead of buying a strangle you sell strangle. Here is how it works!

A short strangle implies selling a call and put of different strikes on the same stock or index. Effectively, you sell a higher strike call and simultaneously sell a lower strike put option. Traders are more comfortable doing short strangles on the index rather than stocks as indices are more predictable and are less vulnerable to company specific and industry specific factors.

How exactly does a short strangle work…

Assume that the spot Nifty is at 10,910. If the trader is expecting the market to be range-bound in a range of about 400 points he can put in place a short strangle. For example, the Nifty 10,800 put is available at a premium of Rs.70 while the Nifty 11,000 call is available at Rs.65. A short strangle strategy can be created by selling 1 lot of Nifty 10,800 put and simultaneously selling 1 lot of 11,000 call option. The total premium income from the short strangle will be Rs.135 (70+65). Here is how the pay off will look like…

Nifty Level

P/L on short 10500 call

P/L on short 10300 put

Total Profit / Loss

10,500

+65

-230

-165

10,600

+65

-130

-65

10,700

+65

-30

+35

10,800

+65

+70

+135

10,900

+65

+70

+135

11,000

+65

+70

+135

11,100

-35

+70

+35

11,200

-135

+70

-65

11,300

-235

+70

-165

11,400

-335

+70

-265

 

The maximum profit on the short strangle is Rs.135 (sum of two premiums) which is realized between the two strikes of 10,800 and 11,000. However, the lower breakeven point is 10,665 and the upper breakeven point is 11,135. As long as the Nifty expires between the levels of 10,665 and 11,135 the short strangle will be profitable. When the Nifty crosses either of these levels on the outer limits, the losses will start to mount. That is when the short strangle can get really dangerous, as we saw in the case of Nick Leeson of Barings.

Why strangles can be risky?

  • Strangle strategies are vulnerable to overnight macro risks. For example if you had sold strangles ahead of the Trade War or Lehman collapse, then you would have been totally wiped out by the losses.
  • Strangles carry a major price risk if you are writing short strangles on individual stocks. Selling strangles on an index is a lot safer. For example, a short strangle on Infosys or Reliance ahead of the quarterly results can be nightmarish for traders. Prefer strangles on broad-based indices over sectoral indices or specific stocks.
  • Volatility is a big risk and works against you in case of short strangles. This risk gets more pronounced when the range gets too narrow. In the above case, if the sharp rise in volatility takes the total premium on the strangle strategy to Rs.175, it will entail paying higher MTM margins. That can impact your solvency.
  • While time works in favour of the call seller and the put seller, a strangle seller is in a slightly different position. When you sell strangles you are exposed to the dual risk of a short call and a short put. Therefore, a strangle strategy with a time to expiry of 20 days can be riskier than a similar strangle with a time to expiry of 10 days.

Strangles can be effective non-directional strategies but you need to be aware of the downside risks. You are effectively taking unlimited risk on both the upside and the downside. Quite often, you may be eventually right but you will be forced to close your position at a loss due to margin pressures. As John Maynard Keynes rightly noted, “Markets can be irrational much longer than traders remain solvent.” That creates the biggest risk strangle strategies!