Profiting in a rising and falling market
Are you undecided in the direction of the market but participate either way?
A bought strangle allows you to lock in a position where you can profit from both a rising or falling market. By using trading warrants you are able to overlay the leverage effect on the performance of the share price, irrespective of its direction.
A bought strangle consists of simultaneously buying out-of-the-money call and put warrants with the same expiry date (i.e. exercise price of the call warrant is higher than that of the put warrant). The underlying asset’s price (share, index, currency) usually trades between both exercise prices when you enter into the strategy.
Bought (long) strangles (and straddles) give you the opportunity to profit from a sharp movement in the price of an underlying asset, where the direction of the move (up or down) is of no importance. In addition, the success of the long strangle also depends on an increase of implied volatility.
Because prices can only move in one direction at a time, one leg of the strategy is likely to make money while the other one loses. To make a profit overall, the combined selling prices must exceed the price paid for this strategy.
The breakeven prices are calculated as the exercise price of the call warrant plus the cost of the strategy, and the exercise price of the put warrant less the cost of the strategy. You also need to take brokerage costs into consideration.
The difference between straddles and strangle
Straddles involve the purchase of call and put warrants with same exercise price, while strangles have different exercise prices. Strangles are generally cheaper than straddles (when the warrants have the same expiry date) as both warrants are out-of-the-money. However, strangles require a greater move in the price of the underlying asset for the trade to be profitable, than straddles.
You are monitoring the AUD/USD exchange rate and you expect the volatility to increase over the next few months, however without any firm view on the direction of the move. A bought strangle using currency warrants will enable you to take advantage of this opportunity.
At the same time you are prepared to risk losing the cost of the put and call warrant if the currency level does not move (a neutral market). Conversely, if the currency rallies significantly (or falls), your profit on the call (or put), should cover the costs of the put/call strategy.
With the AUD trading at US$0.69 (closing price), you select the following warrants:
Buying both a call and put warrant at 19.5c and 19c respectively, the strangle has a net cost of 38.5c (excluding brokerage costs). You can calculate the breakeven points by converting the AUD price for the strategy into US dollars:
A$0.385 * US$ 0.6898 = US$ 0.265.
To make a profit at expiry, the AUD must be trading higher than US$0.7265 or lower than US$0.6235.
After 3 weeks, the AUD rallied from US$0.6898 to US$0.79. Given the appreciation of the AUD, the put warrant is worthless while the call warrant has increased in value and is trading at $1.08.
Overall, taking into account the cost (premium) of the strategy when it was implemented – 38.5c, the profit on unwinding the strategy would be 69.5c (excluding brokerage costs).
The strategy was profitable because the AUD rallied significantly over the life of the warrants. If, on the other hand, the currency remained steady, both warrants would expire worthless.
|Call Warrant||Put Warrant|
|Profit / loss||$0.885||-$0.19|
|Net Profit on Strategy||$0.695|
|Return on investment %||180.5|
Main benefits of the strategy
- Provides exposure to a move in the underlying asset where the direction is unknown
- Possibility of unlimited profits
- Limited downside risk - limited to the cost of the strategy
Main risks of the strategy
- If volatility falls and the price of the underlying asset remains between the two exercise prices, both warrants will expire worthless
- Time decay works strongly against this strategy, as it consists of two bought warrants