Buying an Equity Strangle

Volatility is a friend to buyers of warrants

When markets are volatile and jumping around, buying a call or put warrant can allow you to leverage your exposure on a particular market direction.  However, if you get the direction wrong you will miss out on the opportunity.  That is why if you have a view that the share price is becoming significantly volatile and is going to move in a particular direction but you do not know which (up or down) then straddles can satisfy your appetite.

Buying a strangle over a share is similar to a straddle as it allows you to lock in a position where you can profit from both a rising or falling share price.  The strategy 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 share price usually trades between both exercise prices when you enter into the strategy. By using trading warrants you are able to overlay the leverage effect on the performance of the share price, irrespective of its direction. 

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.  Success execution of this strategy tends to result from the profitable warrant gaining value at a faster rate than the losing warrants position.  An example of this is illustrated below using News Corp (NWS) warrants.

More information on strangles

An example of a strangle over News Corp

With the run up to October, the market reached new record highs with the index hitting 4650.  Many stocks such as NWS benefited from this bullish sentiment.  You as a trader are in two minds about the short term performance of – the share price will continue to go from strength to strength ‘or’ NWS will take a breather and pull back.  Given your contrasting views you decide to buy a NWS strangle using the following warrants, which will allow you to profit from either share price movement – up or down.  Your capital outlay will be $1.56 per share exposure. 

  • NWS share price - $21.60 (3 Oct 2005)
  • NWS warrants

Type Exercise price Ratio Bid price Offer price
Call warrant $22.50 4 20.5c 21.0c
Put warrant $21.00 4 17.5c 18.0c

After 3 weeks, NWS falls from $21.60 to $19.70. This fall results in the NWS put warrants increasing from 18c to 43c while the NWS call warrants falls from 21c to 3.1c   If you unwound the position, selling both the call and put warrant the net gain of the strategy would be 7.2c per warrant (or 28.8c per share) which represents a return on investment of 18% (excluding brokerage costs).

 Put warrant  Call warrant
Buy price 18c 21c
Sell price 43c 3.1c
Profit/loss 25c -17.9c
Net profit of strategy 7.1c (per warrant) 
Return on investment (%)    18.2%

Breakeven calculation

Buying both a call and put warrant at Xc and Xc respectively, the strangle has a net cost of Xc (excluding brokerage costs).  As the strategy contains two warrants with different exercise prices, the strategy will have two break even points – a lower and higher.  The lower is calculated by subtracting the net cost of the strategy from the put warrants exercise price.  While adding the net cost to the call warrants exercise price will calculate the higher breakeven point.  The break even points for this strategy are as follows:

Higher break even point  =   Exercise price ($22.50) + net cost of strategy ($X)   =   $X
Lower break even point   =   Exercise price ($21.50) – net cost of strategy ($X)   =   $X

Main benefits of the strategy

  • Provides exposure to a move in the underlying share 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 share 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

Disclaimer
The information is for educational purposes only and does not constitute financial product advice. ASX does not represent or warrant that the information is complete or accurate. You should consider obtaining independent advice before making any financial decisions. To the extent permitted by law, no responsibility for any loss arising in any way (including by way of negligence) from anyone acting or refraining from acting as a result of this material is accepted by ASX.