Introduction To Short Strangle Option Strategy
The short strangle is also known as “sell strangle”. It is an options trading strategy that sells an out of the money call and an out of the money put derived from the same underlying security and having the same expiration date. By doing so, the trade establishes its neutrality on the price of the underlying security. Therefore, it is also known as a neutral options trading strategy. As a result of the way it is structured, it has a limited profit potential and has unlimited potential losses and risk when the price of the underlying security breaks significantly to the upside or downside.
A Net Credit
Executing a short strangle will result in a net credit.
Steps
Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Assessment Of Outlook – Anticipate Low Volatility
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Potential for unlimited losses
Step 7 : Loss calculation
Step 8 : Limited profit
Step 9 : Maximum Profit Calculation Of A Short Strangle(Sell Strangle)
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade – Executing a short strangle(sell strangle)
Step 12 : Exit Trade – Exiting the short strangle trade
Step 13 : Record Trade’s Performance In Diary
Step 1 : Perform economic, fundamental and technical analysis
The trade must know what are the calendar of events that are to be announced in the near future. These calendar of events may be related to the economy or the underlying security itself. The trader should avoid events which cause volatility in the underlying security to increase. On a fundamental level, the trader should also be certain that the price of the underlying security is fairly valued, meaning, there is little upside or downside to the underlying security. On a technical level, the price of the underlying security should be trading within narrow bands. Some of the chart patterns the traders should look out for are:
The options trader should execute the short strangle in such a way where the price range of the underlying security is expected to trade within the breakeven points of the strategy.
Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis
Step 2 :Assessment Of Outlook – Anticipate Low Volatility
After performing economic, fundamental and technical analysis, the trader should be fairly certain that little volatility is expected in the price of the underlying security. Even better, if the price of the underlying security stays constant till expiration, the written options expire worthless and the trader gets to keep the entire initial credit received.
Step 3 :Study the option chain
Next, the trader should study the options chain. The trader should select the options to be used in the construction of the short strangle. After selecting the options to be used, the trader is able to calculate the net credit and the breakeven points.
Read : Learn to read and understand options chain
Step 4 : Breakeven Analysis
After studying the options chain and knowing premiums of the options to be used, the options trade is able to calculate the breakeven points.
The short strangle has 2 breakeven points. It has an upper breakeven point and a lower breakeven point. At these 2 price points, the trade has neither profit nor loss if liquidated.
The lower breakeven point can be calculated as:
Exercise or strike price of put – net credit received
The upper breakeven point can be calculated as:
Exercise or strike price of call + net credit received
Step 5: Understand Your Profit Zones
After the breakeven points are calculated, the trader will be able to understand where the profit zone is. The profit zone is between the breakeven points for a short strangle.
Step 6 : Potential for unlimited losses
Due to the nature of the short strangle that involves writing naked options, the trade has the potential to turn into a spectacular and unlimited loss. This is so because, the price of the underlying security can go up infinitely or it can go all the way down to 0. A loss will occur when:
- Exercise or strike price of the call option + net credit received < price of the underlying security
- exercise or strike price of put – net credit received > price of the underlying security
Step 7 : Loss calculation
The loss, which dependent on the price of the underlying security can be calculated as:
- Price of the underlying security – net credit received – exercise or strike price of call( This formula can be applied when the price of the underlying security goes up and beyond the upper breakeven point)
- Exercise or strike price of put – net credit received – price of underlying security ( This formula can be applied when the price of the underlying security goes down and below the lower breakeven point)
Step 8 : Limited profit
The short strangle trade involves writing an equal number of out of the money puts and out of the money calls. The calls and puts hence have a different exercise or strike prices. In order for a short strangle to earn the maximum profit, the price of the underlying security must trade between the exercise or strike price of the call and the exercise or strike price of the put. When that happens, all the options expire worthless and the trader gets to keep the entire credit received from writing the options as profit.
Step 9 : Maximum Profit Calculation Of A Short Strangle(Sell Strangle)
Building on the preceding paragraph, the maximum profit is equal to the net credit received when the options were written. Of course, in the real world, a trader that executes a trade through his broker would have to pay commissions to the broker. Hence, the commissions paid to the broker decreases his profit.
The maximum profit can be calculated as:
Credit received – commissions paid to the broker
Step 10 : Calculate Risk & Reward Ratio
When the proper stop losses are in place, the options trader should calculate the risk and reward ratio. This will help the trader determine the attractiveness of a trade on a risk and reward basis.
For example, a risk reward ratio of 1 : 5 is more attractive than a risk reward ratio of 1 : 2.
Read more : Understanding Risk/Reward Ratio For Option Traders
Step 11 : Set Up Trade – Executing a short strangle(sell strangle)
An options trader who executes a short strangle will :
- Short 1 out of the money put option
- Short 1 out of the money call option
The ratio of out of the money written puts to out of the money written calls is thus 1 : 1.
Step 12 : Exit Trade – Exiting the short strangle trade
- If the price of the underlying security trades below the lower breakeven point, the option trader should consider closing out the position at a loss to prevent assignment from occurring when the put is in-the-money.
- If the price of the underlying security trades between the lower and upper breakeven points, the trade is profitable on paper.
- If the price of the underlying security trades at a price above the upper breakeven point, the option trader can consider closing out the position at a loss as the call is in-the-money at this point and there is a risk of assignment occurring.
Step 13 : Record Trade’s Performance In Diary
After the trade has been exited, regardless of the performance, the trade should be recorded in a diary or a journal. This allows a trader to self reflect and to embark on journey of personal improvement. The trader must be able to identify his strengths and weaknesses and find ways to improve on his personal trading algorithm.
Example Of A Short Strangle
The price of ABC Corp currently trades at $50. A trader believes that there is little volatility going forward. The company seems fairly valued. There are no upcoming earnings announcements. He foresees no positive news or negative news. And according to the charts, the price of ABC has been trading within a band of $45 and $55.
He decides to do a short strangle on ABC Corp by:
- Shorting 1 July 55 call @ $1
- Shorting 1 July 45 put @ $1
The net credit received is thus:
($1 + $1) x 100 = $200
When the price of ABC trades at $50 on expiration:
| Beginning value | Ending value | Profit or loss | |
| Shorting 1 July 55 call | $1 | $0 | Profit of $1 |
| Shorting 1 July 45 put | $1 | $0 | Profit of $1 |
| Overall | Total profit of $2 |
When the price of ABC trades at $50, the net credit received is $200 as evidenced above. This is also the maximum profit of the trade. Hence, with little to no volatility, there is a higher probability of a short strangle making the maximum profit.
When the price of ABC trades at $60 on expiration:
| Beginning value | Ending value | Profit or loss | |
| Shorting 1 July 55 call | $1 | $5 | Loss of $4 |
| Shorting 1 July 45 put | $1 | $0 | Profit of $1 |
| Overall | Total loss of $3 |
In this case, the total loss will be $300.
If ABC trades at $80 on expiration:
| Beginning value | Ending value | Profit or loss | |
| Shorting 1 July 55 call | $1 | $25 | Loss of $24 |
| Shorting 1 July 45 put | $1 | $0 | Profit of $1 |
| Overall | Total loss of $23 |
In this case, the loss experienced by the trader who executes a short strangle is $2300. As you can see the greater the magnitude of the swing in price, the greater the potential loss.
If ABC trades at $10 on expiration:
| Beginning value | Ending value | Profit or loss | |
| Shorting 1 July 55 call | $1 | $0 | Profit of $1 |
| Shorting 1 July 45 put | $1 | $35 | Loss of $34 |
| Overall | Total loss of $33 |
Again, with a large swing in the price of the underlying security downwards, the loss is now $3300.
To conclude, the less the volatility of the underlying security, the greater the chance of earning a maximum profit which is equal to the net credit received from the short strangle trade.
Other low volatility options trading strategies
If you are interested in executing a short strangle trade, you may wish to study other similar low volatility strategies such as the short guts, short straddle and the variable ratio write.
Long strangle vs short strangle
A short strangle relies on writing options while a long strangle relies on buying options. While the short strangle is executed in anticipation of low volatility, the long strangle is executed when there is anticipated high volatility.