Options Strategies: Strangle
Options have a unique lego-like quality, meaning structures can be built in complex and creative ways. Not only that, but they can act as the foundational building blocks for other financial products, they are robust, and when used correctly, efficient.
I’m sure you are all -at this point- intimately familiar with Calls and Puts, to those of you who are, it's obvious that on a base level Options are quite simple. In fact, you can only do four things with them. You can Buy a Call (Bullish), Sell a Call (Bearish), Buy a Put (Bearish), and Sell a Put (Bullish). To trade naked Options doesn’t require a degree from MIT, browse the annals of WSB for proof. However, being what they are, we can layer structures, forming webs of complexity that move non-linearly. We don’t need to trade the direction of price but we can instead trade the Volatility itself. Ultimately, Options give us the freedom to scheme, strategize, and build a battle plan with a high probability of success.
We’re not going to elaborate on the mechanics of Volatility just now (that’s for another article), all you need to know -for today- is the Greek Vega, which is a measurement of your Option’s sensitivity to Volatility.
TL;DR
Long Option = Long Vega
Short Option = Short Vega
Here is a brief example to help you contextualize. Think of being long or short a stock. If you are long Vega and Volatility increases your Option value increases ie. you get money! But if you are long Vega and Vol decreases, your Option value will decrease, meaning, you get rekt.
Inversely, if you’re short Vega and Vol decreases, your Option will increase in value, kind of like being short a stock, and if Vol increases your Option will decrease in value.
Trading Options in Crypto is trading Volatility. It’s a double-edged sword, it can either be our best friend or worst enemy, so how do we wield it accordingly?
To flush this out, let’s dig deep into a strategy known as the Short Strangle.
Short Strangle
We should all know by now that Volatility has a mean-reverting property, and now we also know that being short Vega means we make money as Volatility falls. So it stands to reason that building a short Vol position when Vol spikes aggressively might be a good idea.
How would one accomplish this? One way to get short Volatility is by being short a Strangle. A Strangle is simply selling one OTM Put and one OTM Call on the same expiry.
eg.
Short 1x JUN 34.5k Call, 30d
Short 1x JUN 29k Put, 30d
For taking this risk you receive a premium of $2,000 per Strangle.
Below you can see the Greeks of our position, take note of our Vega, both the Call leg and the Put leg are negative. And what do we want to happen when we have an overall negative Vega position? We want Volatility to decrease.
Now, if the Options expire and $BTC is still trading between $24.5k and $29k you simply keep the premium you collected ($2k). If $BTC is trading significantly out of our range, you get a nice email from your friendly neighborhood exchange informing you that you have been liquidated.
The chart below is the PnL curve of our fictitious position. It illustrates what would happen over time as our Strangle nears expiry. You should notice that if the Options expire, and $BTC is still trading between $24.5k and $29k (implying low Vol) you simply keep the premium you collected ($2k).
If Volatility increases and $BTC moves violently in either direction, your Option’s value will decrease drastically. With this strategy, there is potential for unlimited loss, so it’s important to understand the risk and how to manage such a position.
There are two things I want to point out here. First, Volatility is a massive factor when it comes to the price of an Option.
High Volatility = Expensive Options
We want to sell expensive things. Why? First of all, who doesn’t want more money? Secondly, we’re risk-averse, so we want to collect more money up-front which will give us a bigger buffer, let us explain. In the case above we collected $2k for selling 2 Options, but if Vol was lower we might have only collected $1k for selling the same two Options. The premium collected is important because it moves our break-even point further away from the at-the-money (ATM) Option. Meaning we have more room for $BTC to move before we start losing money.
How so you might ask? If you look closely at the chart above we don’t go below the zero bound (at expiration) until $27k on the downside and $37K on the upside, even though we sold the $29k strike and the $35k strike. The more astute among you might have noticed the difference between those strikes, it’s $2k, the exact amount we collected in premium. Our premium has effectively become our buffer.
For now, I want to leave you with three key takeaways:
You can trade Volatility by structuring Options spreads in such a way that you profit from Volatility increasing or decreasing.
Being short a Strangle comes with a higher percentage chance of profit, but unlimited risk if the underlying moves violently in either direction.
Selling Vol is best done in a high IV environment. Remember, expensive Options give you a larger safety buffer. (It also allows for easier management of the position by rolling, but again, for another time.)
Summation
Being short Volatility is pure risk, and hedging only serves to crystalize losses. However, when done properly and conservatively it can be very profitable. Based on experience we believe the key to success is to sell Vol at the right time, don't sell Vol simply because you can. Secondly, knowing when to roll positions is paramount. And finally, never go all in, managing size will go a long way in keeping you above water. In our next article we are going to dive deep into Volatility, how to trade Vols, and how to understand its effect on Option prices.
If you’re interested in constructing this type of position on-chain, Ribbon Vaults allow users to effectively construct a Short Strangle position — by just depositing in the ETH Call Vault + ETH Put Vault at the same time.
