Strangle Adjustment : Nifty Feb 2020 series

Strangle payoff

Introduction

Strangle is one of the most popular trading strategies for option sellers. It tries to capture the underlying within a range by expiry. If that happens, traders profits from both call & put side of the trade. Strangles have a high probability of profit given it allows ample opportunity for trade adjustment in case underlying starts moving violently in a particular direction. As an option seller, knowing how to adjust a strangle is one of the most critical things on the path to sustainable profit.

I am starting this blog to teach a well defined system to adjust a strangle. It is important that a trader knows what to do in each scenario. Each rule should be defined as objectively as possible so that when the time of decision comes, there is no scope for emotions to play any role. I will be trading in Nifty options for 27 Feb expiry. Instead of posting my entire system of strangle adjustment at once, I will keep posting each rule one by one as I use them to adjust my position. This will be a better way to learn as all of you will be learning from real life examples.

For effective learning, I would need support from all the readers to come with questions and ask them without any hesitation. If any of the concepts are not clear, I can write specifically on that rule in more detail in a separate blog.

I will be adding trade logs, rules and crisp logical reasoning after the market closes each day. Each day’s content will be appended below so that we have one place for all our learning. I will start trading sometime this week, once the volatility due to budget and corona virus settles a little.

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Context

  • I will be trading Nifty options of 27 Feb 2020 expiry.
  • I will be using a capital of 6L . This allows me to sell 6 lots of Nifty. 
  • All my positions will be overnight and hence I would not be using any intraday margin. Exception may happen on 27 Feb which is the expiry day.
  • I will keep my capital in Liquidbees and will use that as collateral. This allows me to get fixed monthly returns in form of dividend irrespective of how my strangle does.
  • I will not use all 6 lots at once to setup the strangle. I will use a few to start with and keep remaining for adjustments later. Details will be explained as I take the trade.
  • I will not carry any naked short position overnight. I will always hedge it by buying an option, no matter how OTM. Every option seller should be aware of the risks associated with naked options selling.
  • My strangle adjustment rules rely a lot on an options greek delta. No need to go mathematical. You just need to know the delta value of an option. I will be using the free option chain provided by Sensibull to know the delta of any strike price. If you want to dig deeper, I have explained about delta in this post.
  • I will exit all positions If my loss reaches 2% (Rs. 12000) of my capital.

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Day 2 : 5 Feb

Trade 1

Nifty consolidated around 12025 for most part of the day. In the last 1.5 hour it kept rallying till 12090. Nifty closed with 110 point rally which is not an average move in such a diversified index. Call side again came into trouble and I had to make another adjustment to delta neutralise my position.

Why do I need to adjust ?

At 1:55PM, Nifty was at ~12085, my position delta looked like following:

11350PE : 0.06 x 1

11500PE : 0.09 x 1

12200CE: -0.39 x 1

Net delta = 0.06 + 0.09 – 0.39 = -0.25

Average position delta = (Absolute value of net delta)/(Number of lots sold) = 0.25/3 = 0.0833

Since Average position delta >= 0.075 , it is time to make an adjustment.

How to do adjustment ?

Out of 6 lots, I have 3 more lots available to sell. Hence I can adjust my position by selling more lots on the winning side that is the put side. If I have more lots to sell, I will try to adjust my position by selling options with ~0.15 delta. I will not prefer higher delta options, because I want to keep the winning probability of each side close to 85%. I checked the option chain and found that 11650PE was at 0.15 delta. So I took the following trade:

Exit 1 lot of 11350PE in profit

Sell 2 lots of 11650PE 

Buy 1 lot of 11150PE for risk management

This is how the new delta of my position looks:

11500PE : 0.09 x 1

11650PE : 0.15 x 2

12200CE : -0.39 x 1

Net delta = 0.09 + (0.15 x2) – 0.39 = 0

Effectively, I rolled my 11350PE to 11650PE and locked down some profit. I sold another 11650PE to completely delta neutralise the position. So we see that I was able to neutralise my position with no option on my put side having delta greater than 0.15. Thus I kept my put side winning chance at 85%.

Warning: For the benefit of readers, I am telling a rule in advance which is not used yet. Never sell more than half of the available lots on one side. So if I have 6 lots, I would not sell more than 3 lots on any side. This is because if the market reverses violently, I would not be able to manage 4 lots on the losing side by using just 2 lots on the winning side. In the above example, If Nifty keeps rallying, I will not sell any more put options. Instead I will just keep rolling the put side until it is time to exit the call side in loss. I will cover more details when the situation arises.

Market close summary

Realized P&L for the day : +1713.75

Net P&L for Feb : +1713.75

MTM : -1260


Day 1 : 4 Feb

Trade 1 

The Chinese stock market had started recovering. Nifty opened on a positive note and at 10:00AM it was trading at ~11840. IV percentile had dropped to ~48. Time had come to enter a Strangle and trap Nifty in a range, and earn the theta decay. Only if things would have been so easy! Anyway, I decided to take the following Strangle position:

Sell 1 lot 11350PE

Sell 1 lot 12200CE

Why these strike prices ?

Now the question comes, why did I choose these strike prices ? Simple! I want to be in a trade with ~70% probability of winning. Delta of an option tells the chances that option will end up ITM by expiry. So if i sell an option with 0.15 delta, there is 15% chance it will be ITM and I will lose. So If I chose to sell both CE and PE at 0.15 delta there is a 15% chance of losing on the call side and 15% chance of losing on the put side. Hence a 70% chance of winning (100 – 15 – 15). I went to the option chain provided by Sensibull and checked the deltas. 11350PE and 12200CE had a delta of 0.15. So I decided to sell those options. Traders can choose to sell higher delta options based on their risk appetite. Keep in mind, that no matter what strike price you choose, both should be at same delta. This makes your strangle delta neutral. 

Why make the position delta neutral ?

Again, no need to go too mathematical. A delta neutral position does not make profit or lose as Nifty moves in any direction. The profit comes from time decay. But the catch is we need to keep adjusting our position to keep it delta neutral. As Nifty moves, position loses its delta neutrality and becomes directional.

Risk management ?

This topic is extremely important. We will be carrying our short position overnight. I do not know what may happen tomorrow in world markets. So I need to put some measures to hedge overnight risks. So I took the following position:

Buy 1 lot of 11800PE

Buy 1 lot of 12700CE

There is no delta logic in choosing the strike prices. I usually chose strike price ~500 away from my short option strike price. For each lot sold, I buy 1 lot. You might be wondering if my risk is ~500 points which is too high. You are right. To be losing 500 points, the market would have to move ~1000 points overnight and not reverse till expiry. This would be a once in a few years event. I just want to sleep with peace that even if the worst happens, I do not lose more than my capital. Even in the worst case, I would be losing 25-30% of my capital. Based on your risk appetite, You can choose a farther or nearer width. But no matter what, do not carry naked short position overnight. 

Note: We would not consider deltas of long options while maintaining delta neutrality of the strangle. These options are buy and forget. It is insurance for emergency.

Why sold just 2 lots with a capital of 6 lots ?

If I would have sold all 6 lots at the same time, I would not be left with any lots to make adjustments. I would just have to hope that Nifty remains within my strangle range. Remember, hope is never a good strategy. My rule of thumb is, divide your total available lots into 3 equal parts. Use 1 part to form the strangle. Keep the remaining 2 parts for adjustments later. So 6/3 = 2. I will use 2 lots to set up the strangle and keep 4 lots for adjustments. Do not worry that you are wasting your capital, Nifty does move in a month’s time and all these lots will be used at some point of time. 

Trade 2

Nifty kept rallying for the entire day. At ~1:40 PM, Nifty was trading at ~11965. A 125 points move from when I entered the Strangle. This is a super big move for Nifty. Usually it takes days to give such a big move. But this happened within a span of a few hours. My call side was in trouble. It was time for some adjustment in my strangle. I placed the following order:

Sell 1 lot of 11500PE

Buy 1 lot of 11000PE for risk management

When should I adjust my position ? 

I do the following to decide when to do an adjustment.

I calculate the net delta of my position. Take its absolute value. Then I divide this  value with the number of options I have sold currently. If it comes out to be greater than or equal to 0.075, it is time to adjust. No need to go too mathematical. I follow this formula, because I can very easily delta neutralise this position by selling an option of 0.15 delta on the winning side. Let us understand this with above example:

When Nifty rallied to ~11965, my position had the following delta:

11350PE : 0.10 x 1

12200CE: -0.26 x 1

Net delta = 0.10×1 – 0.26×1 = -0.16 (Ignore the sign, only take absolute value which is 0.16)

Total lots sold = 2

Average delta of position = 0.16/2 = 0.08

Since 0.08 >= 0.075, It is time to adjust.

Now the option chain showed that 11500PE was at delta of 0.15. Since currently Put side is the winning side, I will sell this 11500PE. See how simply I have delta neutralised my position once again. New position:

11350PE : 0.10 x 1

11500PE: 0.15 x 1

12200CE: -0.26 x 1

Net delta = 0.10×1 + 0.15×1 – 0.26 = -0.01 (almost zero)

I will repeat the formula here as It is the only and most important formula to remember for adjustments. It is time to do an adjustment when:

(Absolute value of position delta / number of lots currently sold) >= 0.075

How to adjust my position in the above example ?

Once I have decided that adjustment is needed based on the above formula, I make an adjustment. If I have margin available to sell more lots, I adjust my position by selling 0.15 delta option on the winning side. If I do not have any more lots for adjustment, there is a different rule. We will cover that later once such a situation arrives. In the above example, I sold 11500PE as put was the winning side and 11500PE was at 015 delta. After this adjustment, my position is again delta neutral. Any small movement in Nifty can not hurt my position any more, and I will keep enjoying the benefits of time decay.

Why not just roll 11350PE ?

Many traders will ask that I could have easily delta neutralised the position by rolling the put side. Why all this formula! We could have exited the 11350PE in profit and sold another PE closer to the current ATM strike price. This will instantly lock the profit of 11350PE and make the position delta neutral at the same time. This works, but it has one major problem. If the market reverses, my put side will be in too much trouble too soon. I will explain this using the above example. 

When Nifty rallied to 11965, 12200CE was at 0.26 delta. To delta neutralise by rolling the put side, i will have to sell a put option at 0.26 delta. The 0.26 delta option was 11700PE. If the market reverses, 11700PE will be in trouble much sooner than 11500PE. Also, my probability of winning has greatly reduced by selling 11700PE. Noe my strangle has both sides with delta of 0.26. This means my winning chance is 48% now (100 – 26 – 26). Remember the delta tells the chance an option will go ITM by expiry. By selling 11500PE, I have ensured that my Put side still has the 85% chance of winning. For the call side, I will keep adjusting until the market reverses or I am unable to adjust anymore.

Market close summary

It was a tough day for strangle. Nifty kept rallying for 270 points. But the losses are not yet final, Market can reverse anytime and we still have ammunition for more adjustments. The game is on! There are many more scenarios yet to come, and I have pre-defined rules for each of them. I will explain each of them through real trades when time comes.

Realized P&L for the day : 0

Net P&L for Feb : 0

MTM : -532.5

P&L for 4 Feb
P&L for 4 Feb

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Disclaimer: Options involve substantial risk and are not suitable for all investors. Options investors may lose the entire amount of their investment in a relatively short period of time. It is possible to owe more than you have invested in your brokerage account. Please be aware of your broker’s requirements for trading options. Before you decide to invest in the options market you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a substantial loss which could total more than your initial investment in a short period of time. Therefore you should not invest money that you cannot afford to lose. If you have any questions or concerns regarding the risks associated with option trading, you should confer with a trusted and reliable independent financial advisor. None of the information provided in this blog constitutes a solicitation to trade any investment or security of any kind.

6 thoughts on “Strangle Adjustment : Nifty Feb 2020 series”

  1. Did not understand one thing:
    Day 1
    You added 11500 with out exit 11350
    Day 2
    You added 11650 -2 lots and exit 11350
    The logic behind this is not understand.
    Your explanation is very good bro. It is so helpful.

    1. Thanks for asking, a very valid question.
      In every adjustment, my goal is to make delta of both call side and put side to be equal or as equal as possible. This is called delta neutrality.
      If I have more lots to sell, I will achieve delta neutrality using combination of 2 ways:
      > Selling more options with ~0.15 delta on the winning side
      > Exiting options on the winning side in profit.

      Note:
      I will exit options on the losing side if above 2 does not help me get to delta neutrality. As exiting on losing side locks down the loss.
      > There is no point selling more option on the losing side as this side is already in trouble. It will not delta neutralise the position.

      On Day 1:
      Call side was at 0.26 delta and put side was at 0.1 delta
      By selling 11500PE at 0.15 delta, put side got to 0.25 delta (0.1 + 0.15) which is very close to 0.26 delta of call side. Hence nothing more to be done.

      On Day 2:
      Call side was at 0.29 delta. Put side was at 0.15 delta (0.06 of 11350PE & 0.09 of 11500PE)
      Now i sold 2 11650PE which had 0.15 delta. So new delta on put side becomes : 0.45 (0.06 + 0.09 + 2*0.15)
      To make put side delta equal to call side delta, I just exited 0.06 delta 11305PE. New put side delta becomes: 0.45 – 0.06 = 0.39
      Now both call an put side are at 0.39 delta.

      Once we have decided that adjustment is needed, we need to do these plus minus to make our position as delta neutral as possible.

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