Stock Option Short Strangle Strategy


Stock Short Strangle option strategy 

Background of this strategy 
  1. Hedges minimizes our profit and risk. We cannot go blind w/o hedges which is against my principles of trade. However, hedges that we buy on nifty weekly position expires worthless at the expiry- I was thinking how do we replace this expiring hedge to long term hedge which does not decay with time.
    1. One option is to buy long expiry hedge at high premium to hedge or to buy underlying stocks. 
    2. Buy underlying stock (incase of nifty that can be bought by purchasing 7500 units Nifty Bees) costs almost 7.5 lakhs for each lot of Nifty which hardly gives 500 rs per week and 2 K per month which is very less ROI- hence it it is not worth buying Nifty Bees for hedging purposes
  2.  We are comparatively OK to put up  with the losses on the equity since it is notional but losses on Options positions is realizable on expiry - until we do adjustments to keep rolling up options which involves active tracking / trading - which is not my cup of tea 

Strategy 
  1. Choose stock which is fairly range bound and blue chip and you are ready to keep invested over long term and is willing to accumulate more when the price drops - which means owning it will not yield any losses over long term (inline with above background point 2)   
  2. Buy that stock in quantity equal to the option lot volume when the market dips at a fair valuation ( just like equity investment) - (or) Alternatively if you market is not dropping keep selling the put option till the time you get the shares - this means you are getting paid for waiting till the time stock drops to that level
  3. Once bought, pledge theses shares as collateral for margin .e.g if you have bought ITC 3200 (lot size) for 180 - capital invested is 5.76 lakhs - pledge this and get 5 lakhs margin
  4. Now the underlying shares becomes asset that gives capital appreciation (subject to market movement) and continue paying dividend (subject to company performance) and also serves the margin money for trade    
  5. Sell monthly call options at +10% (probability of achieving this should be low within that month) from the purchase price equal to number of lots of underlying share and keep collecting the premium - this would be approx. 2%-3% return on invested capital if we buy one month in prior. If the call option is expected to expire in ITM - square off before hand or wait till delivery (if the share value is likely to face resistance and lose value due to profit booking or share value is just trending due to speculation) to see if it expires at ITM or at the max give delivery and buy from market     
  6. As the share value appreciates and gains value - start selling the PUT option at strike price above the purchase price (in this case @190 PE) - Hence it is important to buy the shares as much lower price as possible to initiate PUT option selling. This should give additional 2%- 3% ROI taking the overall  ROI to 5% 
  7. 5 & 6 forms short strangle - Repeat this for next month and earn additional 5% 
Risks of the trade 
  1. If the Call option goes in ITM - which means the share is in uptrend and you will have to deliver at call option strike price - 
    1. When you are sure that shares will expire at ITM and if the premium is reasonable (will not yield loss for us) then square off 
    2. Buy the replenishment shares from market at lower price than call strike price or maximum at call strike price (so that the underlying shares- asset is not disturbed) from market and give delivery at call strike price - if the market goes above the call strike at expiry the pocket the profit (or) Put stop loss at bought value to sell to avoid loss due to reversal of trend or profit booking 
  2. If the PUT option goes in ITM - Which means the share is in downtrend and you will have to take delivery at put option strike price 
    1. When you are sure that shares will expire at ITM and if the premium is reasonable (will not yield loss for us) then square off 
    2. Do not do any adjustments and take delivery at PUT options and add to the asset base (requires additional capital)  and sell at market (if the put strike price is closer to share price at expiry) or later when market bounces back (wait if it is likely to bounce)
    3. Sell the shares from asset base in market at higher price than put strike price or minimum at put strike price (before selling, square off call options to reduce margin requirement and arrange for margin since the underlying shares which served as margin is sold) and take delivery at PUT strike price - if the share price @ expiry goes lower than PUT option proce then consider as notional loss 

Max profit: 
  • 5% ROI in the current month short strangle 
  • If the share is likely to continue to be range bound this month and options are like to expire OTM then take position in the next month with the same underlying - double leverage leading to additional 5% ROI  taking total to 10% ROI
  • Alternatively to improve ROI - split the underlying lot between this month and next month e.g if you have 16000 shares (5 lots) take 3 lots position this month (at various levels to mitigate risk) and 2 lots short strangle next month

Max risk : 
  1. If the share trends up- you will have to forego additional profit above the call strike price 10% - Mitigation : 
    1. Need to procure the underlying shares at lower than call strike price 
    2. When the share is over sold choose far off call strike 
  2. If the share trends down - you will have to take the delivery of the the shares at high prices (put strike price) than the prevailing market - leading to notional loss ( if we are ready to wait for the share to recover - leading to interest cost on capital) 
    1. When the share is over bought choose far off put strike 
    2. Need to procure the initial underlying shares at lower than put strike price so that even if we take delivery we are averaging it out bringing the notional loss lower  
Conclusion :

Take this strategy if you are fully convinced about the quality of the underlying stock and you will not regret owning the shares for long term and you are ready to accumulate the shares even at unfavorable prices  


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