A short strangle is an options trading strategy where an investor sells both a put option and a call option with the same expiration date but different strike prices.
This strategy is a neutral strategy that profits when the underlying stock remains within a certain price range. It is called a "strangle" because it involves putting both a call and a put option on the underlying security, effectively strangling its possible price movement.
NEUTRAL OUTLOOK
A short strangle is typically employed when the trader expects the underlying stock to experience minimal price movement in either direction.
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It profits from low volatility and is considered a neutral strategy.
LIMITED PROFIT POTENTIAL
The maximum profit achievable with a short strangle is limited to the premiums received from selling the options.
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The risk is also limited, but it can be significant if the underlying stock makes a strong and sustained move in either direction.
NO OBLIGATION TO EXERCISE
There is no obligation to exercise a long put option.
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In a long put strategy, the investor has the right but not the obligation to sell the underlying asset at the specified strike price before or at the option's expiration date.
PROS | CONS |
Income Generation: The primary goal of a short strangle is to generate income through the premiums received from selling both the put and call options. If the options expire worthless, the seller keeps the entire premium as profit. | Unlimited Risk: One significant drawback of a short strangle is the unlimited risk on the upside. If the price of the underlying asset rises significantly, the call option sold can result in substantial losses. While the risk is theoretically unlimited, in practice, traders can use risk management techniques like setting stop-loss orders. |
Profit in Sideways Markets: A short strangle benefits from low volatility and sideways price movements. As long as the underlying asset stays within the range defined by the put and call strike prices, the strategy can be profitable. | Margin Requirements: Brokers often require a margin to execute a short strangle due to the unlimited risk on the call side. High margin requirements can tie up a significant amount of capital, limiting the trader's ability to take other positions. |
Time Decay: Time decay, or theta decay, works in favor of the short strangle seller. As time passes, the value of the options decreases, leading to potential profits for the seller. | Potential for Large Losses: If the market experiences a sharp and unexpected move, the losses on one side of the strangle (either put or call) can be significant. This is particularly true if there's a sudden and substantial move in the underlying asset's price. |
Flexibility: Traders can adjust the strategy by rolling the options to a different expiration date or adjusting the strike prices, providing some flexibility to manage risk. | Requires Active Monitoring: Short strangles require constant monitoring as market conditions can change rapidly. Traders need to be ready to adjust or close the position if the market moves against them. |
SHORT STRANGLE AND OPTION ASSIGNMENT
The short strangle strategy carries a risk of assignment, and it's important for options traders to be aware of this possibility. Assignment occurs when the owner of the options exercises their right to buy (in the case of a call option) or sell (in the case of a put option) the underlying asset. This can happen if the option is in-the-money at expiration.
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Call Option Assignment: If the stock price rises significantly and the short call option becomes in-the-money, there is a risk of assignment. The call option holder may exercise the option, requiring the trader who sold the call to deliver the underlying stock at the agreed-upon strike price.
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Put Option Assignment: If the stock price drops significantly and the short put option becomes in-the-money, there is a risk of assignment. The put option holder may exercise the option, requiring the trader who sold the put to purchase the underlying stock at the agreed-upon strike price.
SHORT STRANGLE EXAMPLE
Suppose an investor holds a neutral view on the SPDR Dow Jones Industrial Average ETF Trust (DIA) for the upcoming nine days. Envisioning the stock's current trade at $347.47 per share, the strategy chosen to express this neutral outlook involves the execution of a short strangle strategy. In this scenario:
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Sells for $2.46 one call option with a strike of $350 expiring in nine days
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Sells for $1.01 one put option with a strike of $347.50 expiring in nine days
This strategic move resulted in a net credit of $3.47 for the option spread, derived from selling the $2.46 call option and the $1.01 put option. Considering the standard equivalence of one options contract to 100 shares of the underlying asset, the overall credit accumulated stands at $347.
BREAKEVEN POINT
The breakeven points are calculated using two different formulas. The upper breakeven point of $353.47 is calculated by adding the short call strike (350) and the initial entry credit (347) divided by 100. The lower breakeven point of $344.03 is calculated by subtracting the short put strike (347.50) from the initial entry credit (346) divided by 100.
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Short Call Strike + Initial Entry Credit / 100 = Upper Breakeven
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$350 + ($347 / 100) = $353.47
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Short Put Strike - Initial Entry Credit / 100 = Lower Breakeven
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$347.50 - ($347 / 100) = $344.03
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It's important to note that the Initial Entry Credit is the only value divided by 100 for this calculation; not the sum and/or difference of the Short Strike and Initial Entry Credit. It is important that once the stock falls between these two breakeven points, the strategy will continue to accrue profit until the limited profit of $347 is reached.
MAXIMUM PROFIT SCENARIO
Suppose DIA experiences a neutral movement, reaching between $344.03 and $353.47 at the time of expiry. This results in the attainment of a potential profit, amounting to a limited amount of $347.
MAXIMUM LOSS SCENARIO
Should the DIA shares rise or fall above or below the breakeven points (below $344.03 or above $353.47), the investor starts to incur losses. The potential loss is theoretically unlimited because the investor may need to buy back the options at a higher price.
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Unlimited Potential Loss
The investor's undesirable scenario envisions the stock concluding outside the breakeven points upon expiration, thus marking the potential loss for this investor to be unlimited.
In summary, the short strangle strategy presents an opportunity for options traders to capitalize on low volatility environments by selling both a put and call option with differing strike prices but the same expiration date. This strategy thrives when the underlying asset remains within a defined price range, allowing the trader to pocket the premiums received. While it offers limited profit potential, the risk is also capped, though vigilance is required to manage potential losses in case of unexpected market movements. For those looking to leverage income generation and time decay, the short strangle provides a versatile approach to navigating neutral market conditions.
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- Short Strangle. www.fidelity.com/learning-center/investment-products/options/options-strategy-guide/short-strangle.
- “Selling Options: Strangles Vs. Iron Condors.” Schwab Brokerage, www.schwab.com/learn/story/selling-options-strangles-vs-iron-condors.
- Short Strangle, OIC, www.optionseducation.org/strategies/all-strategies/short-strangle.
- “Strangle.” Corporate Finance Institute, 22 Nov. 2023, corporatefinanceinstitute.com/resources/derivatives/strangle/.
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