In this video, we’re going to talk about the short strangle market neutral options strategy. The market outlook for this strategy is that you want a low volatility environment, but you’re going to give yourself a little bit of extra wiggle room in your positioning of the strategy.
This is different than if you look at a short straddle which is going to have closer strike prices and much more of a smaller targeted window of profit. This is going to give you a little bit more room.
With this strategy like I was talking about, you’re going to look for a steady or flat trading stock and slight movements up or down. It’s not going to be a strategy where you need the stock to be 100% flat, close, zero return, no movement at all.
If we take a look at how to set it up, it’s very easy. Just like a short straddle, you’re going to think about it like selling two options and then putting those two options together.
You’re going to simply sell a call and a put with strike prices that are slightly out of the money for the same expiration period. In this case, if the stock is trading at let’s say 40, you’re going to sell a put and sell a call at 45 and 35.
You’re going to sell a put here at 35, and you’re going to sell a call at 45. The more conservative you are on volatility, the further out of the money you are going to sell these options. You don’t have to sell them right out of the money.
You can sell them at 50 and 30 or 60 and 20, whatever you want to do. The more conservative you become, the better overall strategy you have, the more wiggle room you have for the stock to close inside that profit range at expiration.
What's the risk? The maximum risk, in theory, is unlimited. It’s a very risky strategy if you start to get close to the market. Obviously, the stock can rise dramatically, and without unchecked hedging against this and unprotected risk, you can have a very big loss.
But we can mitigate some of that loss with the premium that we receive from the trade (in this case, we received a premium of $200 which is our maximum potential) and we can also mitigate that risk with just one little hedging technique that I’m going to go over at the end of this video.
The profit potential like we talked about is just the maxed to the gain that we received when we sold both options. The more conservative you get, you have a higher probability of making money, but your profit potential may shrink down a little bit because as we get out of the market with our options, they become less and less valuable.
Volatility does have a big impact on this strategy. We do not like volatility when we’re talking about short strangles. It's not as bad as a short straddle. We do have some room for some movement in the underlying stock. It can sway back around 40.
It doesn't have to be pinned at 40. But more or less, increases in implied volatility are going to have a negative impact on this strategy. Remember that short calls are subject to higher prices when volatility increases.
Even if the stock doesn't move, a quick move in implied volatility could create a loss. Even if the stock stays exactly at 40, right where the stock was when we entered this position, increases in overall volatility in the marketplace can have a negative impact on the strategy.
Volatility is very, very important. I tend to prefer to trade these strategies during periods of high to low volatility, not low to high, so keep that in mind.
Time decay is going to be one of our best friends for this strategy. The passage of time decay is going to have a positive impact on the strategy. Remember that options have a finite life, so they have to move quickly or they risk becoming worthless very, very soon.
Because this strategy is short two options, every day that passes has double the impact. We have double time decay on this strategy as compared to a single option, a single short, a single put, etcetera.
Time decay is a profit maker for this particular strategy. If it doesn't move outside of that range and it stays range bound within 35 and 45, then we make money.
Our breakeven points on this are very easy to calculate. As with all market neutral strategies, they’re pretty easy to calculate. The upper level here is going to be your short call strike which is at 45 plus the net premium that you received, in this case, $200.
That is where your upper-level breakeven price would be. On the lower level, it’s going to be your short put strike minus the premium that you receive, that net premium of $200 and that is going to create the lower level breakeven point down here.
Again, very, very easy to calculate, but anything beyond those levels is going to create a loss as per our profit loss diagram. Let’s take a look at a quick example here just to drive home the point.
The stock price was $40 when we entered this trade. We’re going to sell one 45 calls and sell one 35 put, naked selling of these options. Each one of those options is going to be sold for $100 creating a total credit of $200.
Remember that that $200 credit is going to go straight into your account, right out of the gate. You get that right into your trading account. Now, the maximum loss is theoretically unlimited like we talked about before.
The stock could continue to move higher at expiration, so we want to go from periods of high volatility stocks that are already active and that are going to calm down and are going to trade in a tight range.
The maximum profit on this particular strategy is going to be $200 or the premium that we collect. We can’t take any more than that premium. And you can see that visually on the chart here; our profit loss diagram is capped at $200. It doesn't go up any higher than that.
Some tips and tricks for the short straddle that I’ve learned over the years: Many months of consistent profit and income can be wiped out without proper risk management. And this is so true for all strategies, but even more so for some of these short strategies.
If you don’t have proper risk management, and you don’t start conservatively, meaning don’t sell too close to the money, that's the number one reason people lose with the strategy, is that they sell too close to the money, and they take in a huge premium, and then they end up paying out the nose for these strategies later on.
Use them during periods of high to low volatility versus adding them during periods of already low volatility. That’s another key point there that a lot of people miss, is that they add this strategy before the market has a huge breakout.
This is a market neutral strategy for volatility to stay fairly calm, for the stock to stay in a tight range, so you want to add this strategy to the stocks already made a huge breakout and is likely to calm down shortly.
This is the little trick that I was talking about earlier in the video. You can easily hedge this position by purchasing a call or put and creating a credit spread on either end. For example: Let's say that the stock starts moving from 40 towards 50.
We could easily purchase a 50 strike call option and cap our losses after 50. That’d be an easy way to hedge against this whole unlimited risk feature that this thing has right out of the gate.
On the bottom side, if the stock starts moving from 40 down to 30, we could easily buy a 30 strike put and cap our losses from 30 going forward, removing that huge risk feature that we have. But the idea is that you have this in the back of your mind.
Use it when you need it. Don't be jumping all over this hedge if you don’t need it. If the stock is trading in a tight range, you don’t need to hedge the position. But if it starts to break out, then you might want to think about hedging it in one direction or the other.
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