Capturing volatility with a ‘Long Strangle’
- Fri 04 October 2024
An options strategy for when investors expect higher market volatility ahead.
Key points
- This article considers how investors might benefit from a market rally or pullback, using options over Exchange Traded Funds that invest in global equities.
- A range of outcomes scenarios are provided, depending on the ETF’s price, some of which include potential losses.
- The ASX Options Knowledge Hub has information on the features, benefits and risks of options, while Investing in Exchange Traded Products outlines the benefits and risks of ETFs.
Many investors are currently eyeing potential near-term catalysts coming at the back end of this year. With a US election in November, a possible Republican House and Senate might lead to Trump’s proposed corporate tax cuts being given the green light.
Separately, the US Federal Reserve has indicated that interest rates have peaked with Fed chair Jerome Powell stating in his 23rd August Jackson hole speech, “the time has come” (to begin cutting interest rates), which could potentially bode well for markets.
However, slowing Chinese economic growth and reduced consumption may well see markets correct from their current highs, potentially reintroducing concerns about a hard landing in China, as was seen in early August.
International ETFs & Options
Many investors may be aware of how Exchange Traded Funds (ETFs) can be used to gain exposure to international equities.
But the question for investors who are uncertain on market directionality is “How can I benefit from either a rally or pull back without one side being offset by the other?”
In this case, an Option is a tool to potentially benefit from a sizable movement to either market upside or the downside.
The ASX currently has three ETFs with international exposure that investors can trade Options over:
- iShares S&P 500 ETF (ASX: IVV)
- Betashares Nasdaq 100 ETF. (ASX: NDQ)
- Vanguard MSCI Index International Shares ETF (ASX: VGS)
In this article, we’ll step through the use of a Strangle strategy over IVV (iShares S&P 500 ETF), making use of simultaneously holding a bought Call and a bought Put, hoping to benefit from a timely market movement in either direction.
Construction
Note: The below trade uses actual prices as at 12:30 PM on 6th September 2024.
To construct a long strangle, a Call will be bought with a strike price above the current underlying price while a Put will be bought with a strike below the current underlying price.
In this worked example, we have used December 2024 contracts with an approximate 3-month expiry and with a strike price for our Call and Put at $55 and $54 respectively.
Current IVV Stock Price | $54.50 |
Buy 1 x IVVZN7 19-Dec-24 $55.00 European Call | $1.48 |
Buy 1 x IVVZC7 19-Dec-24 $54.00 European Put | $1.56 |
Shares Per Contract | 100 |
Trade Cost* | $304 |
Pay off Diagram:
Source: AUSIEX
Pay off schedule**
IVV Price | % Underlying price change | Trade Cost | Put Value | Call Value | Profit/Loss | % Return |
|---|---|---|---|---|---|---|
$47.50 | -12.8% | $304 | $650 | $0 | $346 | 114% |
$48.00 | -11.9% | $304 | $600 | $0 | $296 | 97% |
$48.50 | -11.0% | $304 | $550 | $0 | $246 | 81% |
$49.00 | -10.1% | $304 | $500 | $0 | $196 | 64% |
$49.50 | -9.2% | $304 | $450 | $0 | $146 | 48% |
$50.00 | -8.3% | $304 | $400 | $0 | $96 | 32% |
$50.50 | -7.3% | $304 | $350 | $0 | $46 | 15% |
$51.00 | -6.4% | $304 | $300 | $0 | -$4 | -1% |
$51.50 | -5.5% | $304 | $250 | $0 | -$54 | -18% |
$52.00 | -4.6% | $304 | $200 | $0 | -$104 | -34% |
$52.50 | -3.7% | $304 | $150 | $0 | -$154 | -51% |
$53.00 | -2.8% | $304 | $100 | $0 | -$204 | -67% |
$53.50 | -1.8% | $304 | $50 | $0 | -$254 | -84% |
$54.00 | -0.9% | $304 | $0 | $0 | -$304 | -100% |
$54.50 | 0.0% | $304 | $0 | $0 | -$304 | -100% |
$55.00 | 0.9% | $304 | $0 | $0 | -$304 | -100% |
$55.50 | 1.8% | $304 | $0 | $50 | -$254 | -84% |
$56.00 | 2.8% | $304 | $0 | $100 | -$204 | -67% |
$56.50 | 3.7% | $304 | $0 | $150 | -$154 | -51% |
$57.00 | 4.6% | $304 | $0 | $200 | -$104 | -34% |
$57.50 | 5.5% | $304 | $0 | $250 | -$54 | -18% |
$58.00 | 6.4% | $304 | $0 | $300 | -$4 | -1% |
$58.50 | 7.3% | $304 | $0 | $350 | $46 | 15% |
$59.00 | 8.3% | $304 | $0 | $400 | $96 | 32% |
$59.50 | 9.2% | $304 | $0 | $450 | $146 | 48% |
$60.00 | 10.1% | $304 | $0 | $500 | $196 | 64% |
$60.50 | 11.0% | $304 | $0 | $550 | $246 | 81% |
$61.00 | 11.9% | $304 | $0 | $600 | $296 | 97% |
$61.50 | 12.8% | $304 | $0 | $650 | $346 | 114% |
Source: AUSIEX
Potential outcomes: risks and benefits
IVV Price < $51
Under this scenario, the Call will expire worthless while the Put will expire in the money (as the underlying price is less than the strike). The intrinsic value of the Put ([Strike price – Underlying price] x Shares per contract) exceeds the value of the cost to implement the trade, leaving the investor in a profitable position.
IVV Price $51-$54
Under this scenario, the Call will expire worthless while the Put will expire in the money (as the underlying price is less than the strike). In this scenario the intrinsic value of the Put does not exceed the cost to implement the trade, and the investor incurs a partial loss if the position is held through to expiry.
IVV price $54-55
Under this scenario, the both the Call and Put will expire worthless as no significant movement in either direction has come to fruition. As such, the value of the trade goes to $0 with a total loss incurred.
IVV Price $55 to $58
Under this scenario, the Put will expire worthless while the Call will expire in the money (as the underlying price is greater than the strike). In this scenario the intrinsic value of the Put does not exceed the cost to implement the trade, and the investor incurs a partial loss if held through to expiry.
IVV > $58
Under this scenario the Put will expire worthless while the Call will expire in the money (as the underlying price is greater than the strike). The intrinsic value of the Call ([Underlying price – Strike price] x Shares per contract) exceeds the value of the cost to implement the trade, leaving the investor in a profitable position.
Additional Considerations
There are several considerations when assessing whether to implement a Strangle.
Firstly, a timely movement is required due to the effect of time decay [1] on options. The longer the underlying stays neutral, the greater the impact of time decay.
Secondly, as the strategy involves buying two legs (options) where at least one leg will expire worthless, a notable movement is required for the trade to be profitable at expiry (in this case, a movement of 6.5% in 12 weeks is required for the position to be profitable).
For these two reasons, a strangle can be useful when there is an upcoming announcement where the outcome is unclear, though the investor believes the outcome will introduce market volatility.
Finally, it’s important to have an exit strategy and understand what action an investor could take if the position moves either in or against their favour, prior to setting the position.
Assumptions:
*Transaction cost are ignored for simplicity.
**The payoff Schedule assumes positions are closed for the intrinsic value at expiry.
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[1] In options trading, time decay refers to the decrease in the value of an options contact as its approaches its expiration date.
About the author
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