There are many ways to reduce risk in the stock market, but perhaps one of the most exciting ways is using the options market. Options give investors a particular set of rules for how they must use them, which can seem restrictive at first glance, but using them correctly reduces your overall portfolio risk level significantly more than what you would expect.
What are strangles?
Options can help you reduce this risk through option strategies known as “strangles”. A strangle gives the investor the ability to profit if moving past a certain point on either side of an underlying security (the “strike price”) or if the price stays within a specific range over time before expiring. These two strategies work well together to reduce your overall risk, but you must be aware of the times at which you should buy or sell each one.
How does a strangle work?
The easiest way to understand how a strangle works is to look at what happens when it is used correctly. Let’s say, for example, that an investor believes that XYZ company will be highly active over the next month and has recently seen some negative sentiment hurt their stock. The investor believes this stock could go up about 25% in the coming months, but they also believe there is a significant risk of the price dropping more than 20%. To take advantage of both possibilities without investing too heavily into either one, our investor can purchase a call option with a strike price of $50 and a put option with a strike price of $45.
If the stock expires in 30 days, this investor will have unlimited profit potential if XYZ goes up 25%from its current market value to over $53 per share. Still, they also can make money if XYZ drops more than 20% from its current price before the expiration. Keep in mind that even though there are only 30 days until it expires, both options cost about 50 cents per day until expiration. That means our investor can really “lock in” their current prices for either possibility without having to be concerned that the stock might drop or rise significantly beyond what they wanted between now and then.
Call and put options.
Of course, you can also use strangles as a way to protect your portfolio and lock in prices at times of market turbulence. You do it just like we described above: by buying both a call and put option with the same strike price and expiration date.
For example, if an investor wanted to protect $10,000 worth of stock from dropping more than 10% (while simultaneously protecting themselves from gains beyond 15%), they could buy one put option with a strike price of $10,500 and one call option with a strike price of $11,000. If the underlying security drops below $9,500 before expiring (in this case, 30 days later), then the put options will be profitable and thus worth more than what the investor paid. At the same time, the call options will be worth less than they originally paid (since the stock would have to rise more than 5% for them to make money).
However, if the shares go up 10% or stay within 15% of where they were at purchase before expiring, both sets of options expire worthlessly. Thus our hypothetical investor would keep their original investment intact.
When you use strangles like this, you are essentially creating a floor that protects your portfolio from loss beyond a certain point but still allows you to profit if conditions improve significantly. That helps reduce risk even further by giving you an additional safety net if the worst happens.
There are times when it seems like everything is on track and nothing could go wrong, but market forces can turn against you without warning. Lock in prices at times of market turbulence with call and put options. Contact a reputable online broker from Saxo Bank to get started with your demo account.