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How risky is a short strangle?

Short Strangle payoff diagram The maximum risk is undefined beyond the credit received. 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 put option could be sold at $95 and a call option sold at $105.

optionalpha.com - Short Strangle Guide [Setup, Entry, Adjustments, Exit] - Option Alpha

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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 Strangle market outlook

Short strangles are market neutral and have no directional bias. Short strangles require minimal movement from the underlying stock to be profitable. Credit is received when the position is opened. Beyond the premium collected, the risk is unlimited above and below the strike prices.

How to set up a Short Strangle

A short strangle consists of a short call option and a short put option with the same expiration date. The short options are typically sold out-of-the-money above and below the stock price. 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.

Short Strangle payoff diagram

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. 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 put option could be sold at $95 and a call option sold at $105. If the position received a total credit of $5.00, the break-even points for this trade would be $90 and $110. The short strangle could be closed 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. If implied volatility decreases, the options contracts’ price will decrease as well, which benefits an options seller.

Entering a Short Strangle

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.

Sell-to-open: $95 put

Sell-to-open: $105 call

Exiting a Short Strangle

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 with a buy-to-close (BTC) order of one or both contracts. If the options are purchased for less money than they were sold, the strategy will be profitable.

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If either option is in-the-money (ITM) at expiration, the contract will be automatically assigned.

Time decay impact on a Short Strangle

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.

Implied volatility impact on a Short Strangle

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 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 can manage the position to maximize the probability of success. If one side of the strangle is challenged, the opposing side could be closed and reopened closer to the stock price. Adjusting the position will result in additional credit. For example, if the stock is trading lower and challenging the $95 short put, 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.

Buy-to-close: $105 call

Sell-to-open: $100 call

Conversely, if the stock is trading higher and challenging the $105 short call, the $95 short put option could be closed and a new put option sold at a higher price. This will tighten the width of the spread, but additional credit will be received to help offset the smaller profit zone.

Buy-to-close: $95 put

Sell-to-open: $100 put

If the underlying asset has moved significantly, the short strangle could be converted to a short straddle by closing the unchallenged short option and selling an option with the same strike price as the challenged side of the position. For example, if the stock price has increased beyond the short call strike price, the $95 short put could be closed and a put could be opened with a $105 strike price. This will increase the credit and expand the break-even point up for the challenged side of the position. The maximum risk is still undefined, but the additional credit helps offset the loss.

Buy-to-close: $95 put

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Sell-to-open: $105 put

If the adjustment collects an additional credit of $2.00, the new break-even points will be $98 and $112.

Rolling a Short Strangle

The short options of a strangle can be rolled out into the future to extend the trade's duration. 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 closed and reopened for a future expiration date. This will likely result in a credit and widen the profit zone. 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 $1.00 credit, the new break-even points will be $89 and $111.

Hedging a Short Strangle

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 has a $95 strike price ,and the stock is challenging the short put’s strike, a long put with a $90 strike price could be purchased to limit risk if the stock continues lower. If the short strangle collected a premium of $5.00 at trade entry, and the long put cost $3.00, the break-even points would tighten to $93 and $107. The maximum profit potential is reduced to $200, but the maximum loss below the long put is the spread width of the put options, minus the overall credit received ($300). However, the max risk is still undefined above the short call if the stock reverses higher.

Buy-to-open: $90 put

Conversely, if the stock price increases, a long call with a $110 strike price could be purchased to define risk if the stock continues higher. If the long call cost $3.00, the max profit potential is reduced to $200 and the max loss becomes the spread width of the call options, minus the overall credit received ($300). The max risk remains undefined below the short strikes if the stock reverses lower.

optionalpha.com - Short Strangle Guide [Setup, Entry, Adjustments, Exit] - Option Alpha

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