One of the features traders enjoy the most about options trading is likely the possibility to earn even in a sideways market. The short strangle option strategy allows this by selling a call and a put with different strike prices. Let’s see how short strangles work both from a theoretical and practical point of view.
Key takeaways
- The short strangle strategy is a setup designed to profit on stable market conditions by selling a call and a put with different strike prices.
- Compared to a short straddle, the short strangle has a wider profit range, a lower maximum loss, a reduced profit, and a lower opening cost.
What Is a Short Strangle?
Let’s begin with a definition: a short strangle is an options strategy that involves selling a call option above the current stock price and a put option below it, both set to expire on the same date. The short strangle option strategy aims to profit when the stock price remains relatively stable within the boundaries of the strike prices.
The profit and loss (P&L) chart of a short strangle will normally look like this:
As you can see, you have a capped profit potential on a relatively large area
Optimal Conditions for a Short Strangle
You will normally go for a short strangle when you feel that the profit probability of the trade is substantially high, so:
- Low market volatility is key, as excessive movement could lead to losses.
- Stocks that have been trading within a narrow range are ideal.
- The strategy works best when the trader expects minimal changes in the stock price.
The primary goal of using a short strangle option is to collect the premiums from both the call and put options, hoping they expire worthless. This means the stock’s price must stay between the two strike prices until expiration, allowing the trader to pocket the premiums as profit.
Comparison with Short Straddle
It’s almost natural to compare this strategy with the short straddle, given their similarities—they both involve selling a call and a put. But how exactly do they differ?
- Strike Prices: In a short straddle, both options are sold with the same strike price. In contrast, a short strangle uses different strike prices for the call and the put.
- Risk Exposure: A short strangle generally provides a wider safety margin, reducing the overall risk compared to its counterpart. However, this comes at the cost of typically lower premiums.
- Profit Range: The profit potential in a short strangle is capped at the premiums received. The other strategy may offer a tighter profit margin but carries more risk due to its closer strike prices.
Using the sell strangle option strategy can be a valuable tool for traders expecting stability. It allows for a broader range of profitability compared to similar strategies, while maintaining a slightly lower risk of loss due to its wider strike price gap.
A Real-Market Example of a Short Strangle
Examples can often tell you more than theories ever could. Let’s consider a short strangle using MongoDB (MDB) as a real-market example. You believe MDB is likely to move within a range for the next few weeks. This belief could stem from the absence of upcoming earnings reports for MDB and its main competitors, coupled with technical indicators suggesting a sideways trading phase. Regardless of your reasoning, you’re ready to set up a short strangle on MDB.
Suppose MDB is trading at $290. Our options screener indicates an opportunity to sell a $250 put and a $325 call, both expiring in two weeks, as you can see here:
These strike prices are quite wide, which is typical for a short strangle option strategy. As you see from the chart above, this setup promises a maximum profit of $332, but it comes with the potential for unlimited losses if MDB’s price moves beyond the $246.68 to $328.32 range.
Why Consider This Strategy?
Let’s say there are at least three reasons to opt for this strategy:
- No Upcoming Earnings: No immediate catalysts that could drastically change MDB’s price.
- Technical Indicators: Suggests stability, offering a favorable environment for this strategy.
- Historical Data: MDB’s price has remained between these strike prices for the past couple of months.
As a reference, here is the historical price chart of MDB:
By setting up this short strangle, you aim for another two weeks of stability, hoping the stock price remains within the strike prices. The moment both options expire worthless, you get to pocket the premiums, making this a profitable venture.
Key Points to Remember
To better understand what comes next in our article (especially the next section on pros and cons of this strategy), remember these features about our example:
- Maximum Profit: Limited to the $332 premium received.
- Risk: Potentially unlimited if the stock moves outside the strike range.
- Strike Prices: Wide to accommodate slight movements, reducing risk compared to tighter options like a straddle.
Traders who use the sell strangle option strategy often look for stocks like MDB that show consistent price ranges. This strategy can yield profit without needing large market swings, making it suitable for periods of expected stability. Always consider historical data and market conditions to ensure your approach aligns with your expectations.
Advantages and Disadvantages of the Short Strangle Options Strategy
Having seen a practical example, it’s certainly easier to grasp the nuances of options strategies. In this section, we’ll explore the pros and cons of the short strangle options strategy, helping you decide if it might suit your trading goals. Here is a table that summarizes the advantages and disadvantages of this strategy:
Pros
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- Greater Percentage Profit Over Time: The short strangle option strategy offers wider breakeven points, which can result in a more likely profit. This trick allows the underlying asset to move within a broader range while still maintaining profitability, which can be beneficial in stable market conditions.
- Time Decay is On Your Side: Time decay, or theta, works in favor of the short strangle (we’ll tell you more about this in a minute). As time passes, the value of the options decreases, potentially leading to profits if the stock price remains stable. This decay accelerates as the options approach expiration, which can help the trader earn quicker returns.
Cons
- Lower Profit Potential Compared to Short Straddles: Although it is cheaper to open, the short strangle option strategy generally offers lower profit potential compared to short straddles. This is due to the lower premiums collected, as the options are further out-of-the-money.
- Unlimited Risk if Stock Price Moves Significantly: One of the significant risks associated with short strangles is the exposure to unlimited losses if the stock price experiences a significant move in either direction. This can happen if unexpected news or events cause volatility in the stock market, leading to potentially catastrophic losses.
- Large Margin Requirements: Because of the unlimited risk, brokers typically require a large margin to cover potential losses. This can be a drawback for traders with limited capital, as a significant portion of their trading account might be tied up to meet margin requirements.
Therefore, while the short strangle can be a cost-effective strategy with favorable time decay benefits, it comes with inherent risks that must be carefully managed. Traders should weigh these advantages and disadvantages against their market expectations and risk tolerance before implementing this strategy. If you manage to understand the potential rewards and risks, you’re certainly one step ahead of the average investor.
Impact of Time Decay and Implied Volatility
Let us open this short section with a table summarizing the effects of time decay and implied volatility on a short strangle trade:
We briefly mentioned time decay earlier, and it plays a crucial role in the strangle strategy.
Time decay, or theta, benefits the short strangle option strategy by reducing the value of both call and put options as expiration nears. If the underlying stock remains stable, this gradual loss in value allows the investor to potentially buy back the options for less than they were sold, locking in a profit.
Implied volatility (IV) plays a crucial role in the performance of short strangles. To maximize this strategy, it’s best to sell options when you anticipate a drop in IV. Higher IV results in inflated premiums, so entering the trade during periods of elevated IV and exiting as it decreases can lead to profit as option prices decline.
Understanding these factors is essential for anyone considering the sell strangle option strategy, as they can greatly influence the potential for profit or loss.
Is There an Early Assignment Risk When Trading Short Strangles?
The short answer is that yes, there is an early assignment risk when you choose the sell strangle option strategy. When a short strangle option goes deep in-the-money, the risk of early assignment increases.
Both short calls and puts in this strategy can be assigned early, particularly if they are in-the-money and tied to dividends. If the stock price surpasses the call’s strike or falls below the put’s strike, the potential for early assignment is heightened. It’s crucial to monitor these scenarios closely and take action if necessary to avoid unwanted stock positions or increased costs.
More Considerations on the Short Strangle Options Strategy
As options traders, we feel there are a few practical tips you normally need to know before diving into short strangle strategies.
Firstly (and we have already told you about this, but “repetita iuvant,” as the Ancient Romans used to say), understanding the difference between short strangles and short straddles is key. While both involve selling calls and puts, short strangles have different strike prices, offering wider breakeven points.
This makes them generally less risky than short straddles, as they require more significant price movement in the underlying asset to hit those points. However, this also means they typically yield lower premiums compared to the previously mentioned strategy.
Adjusting Short Strangles
Short strangles provide flexibility through adjustments. Traders can manage risk by rolling or adjusting strike prices. Here’s how:
- Rolling Options: If a short strangle option is nearing expiration and remains unprofitable, the position can be rolled forward. This involves closing the current position and opening a new one with a later expiration date, potentially capturing additional credit and extending the trade’s duration. For example, rolling a $110 call and a $90 put from July to August might yield extra credit and adjust breakeven points beneficially.
- Adjusting Strike Prices: If market movements threaten one side of the strangle, traders can adjust by closing the opposite side and reopening at a more favorable strike price. This action not only protects against losses but can also increase profits by collecting additional premiums.
Market Conditions and Exit Strategies
Using short strangles in different market conditions requires finesse. They perform best in stable or neutral markets where significant price movements are not expected. Traders should remain alert to market news or events that might increase volatility, impacting the strategy’s effectiveness.
Having a well-defined exit strategy is crucial. This includes setting predefined loss thresholds and profit targets to avoid emotional decision-making. Knowing when to adjust, roll, or close a position helps in maximizing gains and minimizing losses.
