Short Strangle

When to Apply a Short Strangle

You would use the short strangle when you have a neutral outlook on a security (i.e. you don’t think its price will move dramatically in either direction), but you want to allow for a little more price movement than the short straddle allows. Substantial losses are possible if the security does happen to go up or down in price significantly, so it should really only be used when you are confident that such a scenario won't happen.

You will need a high trading level with your broker to apply this spread, so it isn't suitable if you don’t have much investment capital (although the spread produces an upfront credit, it does require margin) or you only have limited trading experience.

How to Apply a Short Strangle

This is a straightforward matter of writing call options on the relevant underlying security while writing an equal amount of puts on the same security. You do have a couple of decisions to make though.

First you must decide upon an expiration date; there are no hard and fast rules regarding this other than the fact that you must use the same expiration date for both transactions. A shorter term expiration will essentially give you a better chance of making a profit, because there will be less time for the price of underlying security to move. Using a longer term expiration will carry a greater risk, but they will be more expensive so you'll receive a higher credit.

The second decision is regarding what strikes to use. Unlike the short straddle, where you write at the money contracts, you need to write out of the money contracts. You must decide how far out of the money you want them to be. The further out of the money they are, the more the price of the underlying security will have to move for the strategy to result in a loss. However, options get cheaper the further out of the money they are, so you'll receive less money for writing far out of the money contracts.

Here is an example how you might apply this spread.

• Company X stock is trading at $50, and your expectation is that the price will stay close to $50.
• Out of the money call contracts (strike $54) are trading at $.50. You write 1 of these (containing 100 options), for a credit of $50. This is Leg A.
• Out of the money put contracts (strike $46) are trading at $.50. You also write 1 of these, for an additional credit of $50. This is Leg B.
• The short strangle has been created for a total credit of $100.

This example doesn't use exact market data, and the prices are hypothetical. We have not included commission fees in the transactions.

Profit & Loss Potential

The profit you can make is limited to the amount of the upfront credit, which is $100 in this case. You would make the maximum profit if the underlying security was trading between the two strikes ($46 and $54).This would mean that both legs would expire worthless, so you would have no liabilities and the upfront credit would be kept as profit.

You would lose money if the price of the underlying security moved too far in either direction, because the options written could result in a liability greater than the net credit received. Potential losses are unlimited. The relevant calculations for profits, losses, and break-even points are as follows.

• Maximum profit is made when “Price of Underlying Stock = or < Strike in Leg A and = or > Strike in Leg B”
• Maximum profit is the net credit received, i.e. “(Price of Options in Leg A x Number of Options Written) + (Price of Options in Leg B x Number of Options Written)”
• The short strangle has two break-even points; the upper break- even point and the lower break-even point.
• Upper Break-Even Point = “Strike of Leg A + (Price of Options in Leg A + Price of Options in Leg B)”
• Lower Break-Even Point = “Strike of Leg B – (Price of Options in Leg A + Price of Options in Leg B)
• The short strangle will result in a profit providing “Price of Underlying Security < Upper Break-Even Point and > Lower Break-Even Point”
• The short strangle will return a loss when “Price of Underlying Security > Upper Break-Even Point or < Lower Break-Even Point”

Your position can be closed at any time before expiration by using the buy to close order to buy back the options in both legs. You can do this to lock in profits if the options are trading at a price lower than when you wrote them. You can also do this to prevent (or limit) losses if the security looks like moving (or has moved) beyond one of the break-even points.

Short Strip Strangle & Short Strap Strangle

This spread comes in two other forms too: the short strip strangle and the short strap strangle.

The short strip strangle is applied by writing a higher number of puts than calls, while the short strap strangle is applied by writing a higher number of calls than puts. You would use one of these variants if your outlook was neutral, but you felt there was a chance the price of the underlying security could go up (use the short strip strangle) or go down (use the short strap strangle).

Because these variations involve writing more options, the upfront credit received is higher. The flip side to this is that the losses will be greater if the price of the underlying security moves too far in the wrong direction.

Summary

This is a fairly simple way to profit from a neutral outlook, but there are substantial risks involved. It has a greater chance of profiting than the short straddle, but the maximum profit is lower. You'll need a high trading level to use the short strangle, and margin is involved. It should only be used if you are very confident that the price of the underlying security won't move substantially in either direction.