Straddle or Strangle? Which Options strategies could help protect investments in the current scenario

The Nifty VIX (volatility index) is often inversely related to the Nifty 50. When the Nifty falls dramatically, volatility increases. When the Nifty has record positive performance, volatility decreases. Interestingly, when the VIX is at its highs and lows, there tends to be lower Options trading volume.

Traders who only focus on bullish or bearish outcomes limit  themselves  to profiting solely from directional Options trading strategies. These are exactly what they sound like – strategies that win based on the trader being correct on the direction of the underlying index’s (or stock’s) movement.

For example, if the trader believes that the underlying will move up, the preferred Options trading strategy could be a long call Option or long bull Call spread. On the other hand, if the trader believes that the underlying will move down, the preferred Options trading strategies could be a long Put option or long bear Put spread.

But whether the VIX is high or low, there are unique Options trading opportunities that emerge in the form of non-directional trading strategies. An alternative to directional Options trading strategies, these strategies win regardless of how the underlying moves, or not; the direction doesn’t matter. Further, there are opportunities to purchase low-cost equity hedging which could reduce your downside risk should a stock that you own dramatically drop in price.

The price of an Option is based on the time to expiry, the price of the underlying, the strike price, the volatility, and the prevailing interest rate. When market volatility is low, then the price to purchase Options – both Calls and Puts – is less expensive than when volatility is high.

Think about it this way: if the Nifty all of a sudden crashed 10 percent in a day, traders will want to do one of two things.

First, traders would buy Put options on stocks to protect their portfolio against a further downside. This higher demand for Puts will drive up the prices of Put Options, and subsequently, the implied volatility of Put Options.

Secondly, traders would buy Call Options speculating that the market will sharply bounce back. This higher demand for Calls will increase their price and the implied volatility of Call options. This increased implied volatility for both Calls and Puts will be reflected in the higher VIX value.

On the other hand, if the market has been on a steady incline, the opposite happens. Traders are less interested in buying Puts to protect against downside equity movements, and fewer traders speculate on drastic upswings in the market. This translates into lower demand for Calls and Puts, which leads to lower VIX values, and thus, less expensive Options. Thus, a low VIX presents us with a few opportunities.

Opportunity #1: If you believe that the market will continue to stay flat or move only small amounts, then a trader can earn through non-directional Options strategies for flat markets. These strategies include Iron Condors and Short Straddles / Strangles. Do note though, that because of the low volatility, the yield that the trader will earn will be less than when the market has higher volatility. However, with these strategies, one could have a higher success rate in a flat market  than in a volatile one.

A Short Straddle consists of selling an at-the-money (ATM) Call and a Put for the same expiry date. The maximum gain occurs when the underlying price doesn't move. This is a credit strategy where the trader collects an upfront premium. The drawback of a short straddle is that you can incur a large loss if you are wrong in your  forecast with respect to your short Calls and Puts.

A Short Strangle is like a Short Straddle, except that the shorted Calls and Puts are out-of-the-money (OTM). This allows the underlying to move more prior to the trader taking a loss, the trade-off being that the upfront premium is less than that of a comparable Short Straddle.

An Iron Condor is a hedged Short Strangle. You start with a Short Strangle but also purchase a deeper out-of-the-money (OTM) corresponding Call and Put. The Call and Put Options purchased reduce the initial premium received. However, your maximum loss is now capped by the strike prices of the purchased Calls and Puts.

Opportunity #2: If you believe that the market will be more volatile in the coming weeks than it is now, you can purchase non-directional Options strategies for volatile markets. Specifically, traders could purchase long straddles or long strangles. These Options strategies offer a double benefit to traders in times of low volatility. One, these strategies will pay out if the market moves substantially. Two, returns could also increase if volatility broadly increases from the current low levels.

A long straddle consists of purchasing an at-the-money (ATM) Call and Put with the same expiration date. If the underlying security moves upwards, then the payoff will be similar to a Call option. If the underlying price closes up significantly at expiration, the Call will be valuable but the Put will be worthless. Conversely, if the underlying security moves downwards, then the payoff will mimic that of a Put option. The maximum loss for this strategy is the cost of the Call and Put option.

A long strangle is similar, except you purchase out-of-the-money (OTM) Calls and Puts. This lowers the cost of entering into the strategy compared to a straddle.

Opportunity #3: If you own stocks that have Options available for them and you are concerned that this stock could suffer from a loss in value – perhaps due to an upcoming earnings announcement or as a result of a market pullback – then you can take advantage of this low volatility environment. Specifically, you can purchase a Put Option on those stocks. Due to lower market volatility, buying Put options is cheaper than is usually the case.

Options strategies are at their most effective in market situations like the one we are experiencing in India today. As shown above, a well-thought-out strategy could be a good way to protect one’s investments in such a scenario.