Short strangles consist of selling an out-of-the-money short call and an out-of-the-money short put for the same expiration date. The strategy capitalizes on minimal stock movement, time decay, and decreasing volatility.
Short strangles are market neutral and have no directional bias. Short strangles capitalize on a decrease in volatility and minimal movement from the underlying stock to be profitable. Credit is received when a short strangle position is opened. Beyond the premium collected, the risk is unlimited in both directions. An investor would look to initiate a short strangle when the belief is the stock price will stay relatively flat before expiration and implied volatility would decrease.
A short strangle is made up of a short call option and a short put option sold out-of-the-money with the same expiration date. The combined credit of the short call and short put define the maximum profit for the trade. The maximum risk is undefined beyond the credit received.
The short strangle payoff diagram resembles an upside-down “U” shape. The maximum profit on the trade is limited to the initial credit received. The maximum risk is undefined beyond the credit received and is unlimited. The break-even point for the trade is the combined credit of the two options contracts above or below each strike price.
For example, if a stock is trading at $100, a call option could be sold at $105 and a put option sold at $95. If the position received a total credit of $5.00, the break-even points for this trade would be $110 and $90. The short strangle could be exited anytime before expiration by purchasing the short options. If the cost of buying the contracts is less than the initial credit received, the position will result in a profit. Implied volatility will have an impact on the price of the options. As implied volatility decreases, the options contracts’ price will decrease as well, which works in favor of an options seller.
To enter a short strangle, sell-to-open (STO) a short call above the current stock price and sell-to-open (STO) a short put below the current strike price for the same expiration date. For example, if a stock is trading at $100, a call option could be sold at $105 and a put option sold at $95. Higher volatility will equate to higher option prices. The longer the expiration date is from trade entry, the more the options will cost, and the more premium will be collected when sold.
A short strangle looks to capitalize on time decay, minimal price movement in a stock, a drop in volatility, or a combination of all three. If the underlying stock price stays between the short options, the contracts will expire worthless at expiration, and all credit received will be kept.
Any time before the expiration, the position can be exited by buying-to-close (BTC) the short contracts. If the options are purchased for less money than they were sold, the strategy will be profitable.
Time decay, or Theta, works in the advantage of the short strangle strategy. Every day the time value of an options contract decreases. Ideally, the underlying stock experiences minimal movement, and theta will exponentially lose value as the options approach expiration. The decline in value may allow the investor to purchase the options contracts for less money than initially sold.
Short strangles benefit from a decrease in the value of implied volatility. Lower implied volatility results in lower options premium prices. Ideally, when a short strange is initiated, implied volatility is higher than it is at exit or expiration. Future volatility, or Vega, is uncertain and unpredictable. Still, it is good to know how volatility will affect the pricing of the strangle options.
Short strangles can be adjusted to extend the time horizon of the trade or adjusted by rolling one leg of the option up or down as the price of the underlying stock moves. If one side of the short strangle is challenged as the contracts approach expiration, an investor has two choices to maximize the probability of success. The entire position can be closed and reopened for a later expiration date. If this results in a credit, the break-even points will be extended by the amount of premium received.
For example, if the original short strangle has a $105 call and $95 put with a June expiration date and received $5.00 of premium, the investor could buy-to-close (BTC) the call and put option, and sell-to-open (STO) a new position in July. If this results in a credit of $2.00, the new break-even points will be $112 and $88.
If one side of the strangle is challenged, the opposing side could be rolled in the stock price direction to receive additional credit. For example, if the short put is sold at $95 and stock is trading at $90, the $105 short call option could be closed and a new call option sold at a lower price. This will tighten the width of the spread, but additional credit will be received to help offset the smaller profit zone.
The short options of a strangle can be rolled out into the future, and/or the strike prices can be rolled up or down to maximize the potential profit on the trade. The passing of time works in favor of an options seller. But if time is running out before expiration and the position is not profitable, the original strangle may be repurchased and sold for a future expiration date. This will likely result in a credit and help extend the trade’s time duration and extend the profit zone.
Strike prices can also be rolled up or down if the stock price is challenging one leg of the strangle. If the underlying stock price has moved up, the original put option can be repurchased and resold at a higher price. This will collect more premium.
Hedging short strangles can define the risk of the trade if the underlying stock price has moved beyond the profit zone. To hedge against further risk, an investor may choose to purchase a long option to create a credit spread on one or both sides of the short strangle.
For example, if the short put of the strangle is at $95, and the stock is trading at $90, a long put could be purchased to cap the downside loss. If the $90 put were to be purchased, the most that could be lost is $5.00, minus the position’s net credit. Buying the put will cost money, but it will limit the potential risk if the stock continued to fall.