What are the risks of writing / selling a short strangle - Motilal Oswal
What are the risks of writing / selling a short strangle - Motilal Oswal

What are the risks of writing / selling a short strangle?

One of the popular advantages of using options is that you can create non-directional strategies. Normally, any position in the stock market is based on your view on the market which is either bullish or bearish. But what if you are just expecting the market to get volatile but are not sure whether the volatility will be on the upside or on the downside? That is where non-directional strategies come in handy. One such non directional strategy is “The Strangle”. Let us look at short strangle option strategy more from the perspective of a writer / seller than a buyer. Let us also understand the risk of short strangle and how to do short strangle risk management. 

What exactly is a short-strangle?
To understand short strangle, let us first look at it from the point of view of the buyer and then transpose it to the seller. Check out the live Nifty Options chart below.

Data Source: NSE

A long strangle entails buying a put with strike lower than the spot price and buying a call that is higher than the spot price. Since the spot price of the Nifty is 10,680, we can create a Strangle by buying 1 lot of 10,700 calls and simultaneously buying 1 lot of 10,650 put. The total cost of the Strangle will be Rs.198.65 (103.55 + 95.10). That will be the minimum movement requirement. Therefore for a buyer of the Strangle; either the Nifty will have to move below 10,451 or the Nifty must move above 10,898. Essentially, you buy a Strangle when you expect extreme volatility in the Nifty but are not sure of the direction.

We can just reverse the above situation and get the payoff for the seller of the Strangle. The seller will be profitable as long as the Nifty is within the range of 10,451 on the downside and 10,898 on the upside. For the seller, of the Strangle, this strategy is profitable if Nifty is within the range but can result in losses if it goes outside the range.

Barings Case and the risks of short strangles
The best way to understand the risks of short strangles is through the Barings example. Back in 1995, Barings was led by star trader, Nick Leeson, in Singapore. He had heavily sold strangles on the Nikkei index. When the Kobe earthquake struck Japan and the index crashed, it resulted in huge losses. The entire capital of Barings got wiped out in one go and the bank had to be sold for just £1. Let us look at some key risks of selling strangles.

Strangle strategies are vulnerable to event risks. For example, selling strangles ahead of major events like budget, Fed meetings; geopolitical events etc can be quite dangerous. As an option seller, you are normally leveraged and this can come back at you in a big way, when there is a sharp rise or a sharp correction in the index.

Relatively, short strangle strategies on indices are safer than writing short strangles on specific stocks. For example, if a trader had tried selling short strangles on F&O stocks like Yes Bank, Dewan Housing, Indiabulls Housing etc, the losses would have been out of control. We are not even talking about the likes of PC Jewellers here.

Overnight risk is something that is very hard to control. Today the markets are highly integrated and any overnight announcements in the US or Europe can lead to a sharp movement in opening trades. When Lehman went bust or when the taper was announced in 2013 by the Fed, Indian markets displayed huge gap-down openings. In such cases, short strangles can be really dangerous.

Forget price, even volatility can work against you in short strangles. In the above case of the Nifty strangle, the total premium income is Rs.198.65. Even assuming that the Nifty does not move but the VIX moves up due to the upcoming Fed meet, things can quite bad. For example, if both the call and put become more valuable to a price of Rs.230, then, the Rs.31.35 MTM losses will have to be immediately provided for. So, it is not just about actual price movement but also about volatility which influences option prices.

Is there a way out for writers of Strangles?
Volatility continues to be the single biggest risk for sellers of Strangles since there is the dual risk of calls and puts. Here are 3 points strangle writers can keep in mind to manage risk.

Never get into a short strangle without a strict stop loss on the spot Nifty level. This is a discipline that you need to adhere to, irrespective of your view. Of course, the overnight risk still remains.

Preferably, short Strangles must be supported by underlying positions. If strangles are more of a hedge, then it is ok because you have an underlying asset to support. But writing naked short strangles is fraught with risk.

Keep a margin limit for yourself. When you sell options, you are subject initial margins and MTM margins like futures. Keep a limit till which you will fund margins and cut the position beyond that. This is a very common method of handling short strangle risk.

Ready to invest with us?

Share your Mobile Number with us and get started

  • +91|