A short strangle
strategy is an advanced options trading technique designed to profit from low
volatility in the market. It involves selling (also known as writing) both a
call and a put option at different strike prices, typically equidistant from
the current price of the underlying asset, but with the same expiration date.
The goal is to collect the premiums from the options while expecting the asset
to remain within a certain range, thereby allowing the options to expire
worthless.
Overview of the short
strangle strategy
The short strangle
is a neutral strategy because it doesn’t depend on the market moving in a
particular direction. Instead, the trader expects that the underlying asset
will not make any significant moves before the options expire. If the
underlying asset remains relatively stable and does not breach the strike
prices of either the call or the put option, the trader keeps the premium
received from selling the options. However, if the asset moves significantly,
especially beyond the strike prices, the trader could incur significant losses.
To better understand
the short strangle strategy, let’s break it down into key components:
1. Components of a
short strangle
Short call: This is the bearish part of the strategy. When
you sell a call option, you are obligated to sell the underlying asset if the
asset’s price exceeds the strike price. You profit if the asset stays below the
strike price of the call option at expiration.
Short put: This is the bullish part of the strategy. By
selling a put option, you agree to buy the underlying asset if its price falls
below the put’s strike price. You profit if the asset remains above the strike
price of the put option at expiration.
2. Construction of a
short strangle
To construct a short
strangle, the trader follows these steps:
Step 1: Select an underlying asset.
Step 2: Choose a strike price for the call option that
is above the current market price of the asset.
Step 3: Choose a strike price for the put option that
is below the current market price of the asset.
Step 4: Sell both the call and the put options. The
trader receives a premium for both the call and put options.
Both options
typically have the same expiration date, and the strike prices are often
equidistant from the current market price of the underlying asset.
3. Profit and loss in
a short strangle
Profit potential:
The maximum profit
from a short strangle strategy is the total premium received when selling both
the call and put options. This is the case when the underlying asset's price
remains between the strike prices of the two options at expiration, allowing
both options to expire worthless. The trader keeps the premiums without having
to buy or sell the underlying asset.
Maximum Profit =
Premium from Call Option + Premium from Put Option
For example, if you
sold a call option for Rs.3 and a put option for Rs.2, your maximum profit
would be Rs.5 per share (Rs.500 per contract, as each options contract
typically represents 100 shares).
Loss potential:
The risk in a short
strangle strategy is theoretically unlimited on the upside and substantial on
the downside. If the underlying asset’s price moves significantly higher or
lower than the strike prices of the options, the trader may face substantial
losses.
Loss on the upside
(call side): If the price of the
underlying asset exceeds the strike price of the call option, the short call
incurs losses. As the price of the asset rises, the trader may have to sell the
asset at the strike price while the market price is much higher, resulting in a
loss equal to the difference between the market price and the strike price
(minus the premium received).
Loss on the downside
(put side): If the asset’s price
falls below the strike price of the put option, the trader may be forced to buy
the asset at the strike price, which could be higher than the market price.
This results in a loss that grows as the price falls further below the strike
price of the put option.
Maximum loss (on the
upside) = ∞ (Unlimited loss as the
stock price can rise indefinitely)
Maximum loss (on the
downside) = Strike Price of Put –
Premium received (since the stock price can only fall to zero)
4. Breakeven points
There are two
breakeven points in a short strangle strategy, one for the call option and one
for the put option. These points define the price levels beyond which the
strategy starts incurring losses.
Upper breakeven point
= Strike Price of Call Option + Net
Premium Received
Lower breakeven point
= Strike Price of Put Option – Net
Premium Received
If the price of the
underlying asset remains between the two breakeven points, the trader will make
a profit.
5. Example of a short
strangle
Let’s assume the stock
of XYZ Corporation is trading at Rs.100. A trader sells a call option with a
strike price of Rs.110 for Rs.3 and sells a put option with a strike price of
Rs.90 for Rs.2. The total premium collected is Rs.5.
Maximum profit: The trader will make a maximum profit of Rs.5
per share if the price of XYZ remains between Rs.90 and Rs.110 until the
options expire. Both the call and put options will expire worthless in this
scenario, and the trader will keep the Rs.5 premium.
Breakeven points: The breakeven points are Rs.115 on the upside
(110 + 5) and Rs.85 on the downside (90 – 5). If the price of XYZ is outside of
these points at expiration, the trader will start to lose money.
Potential losses:
If the price rises
above Rs.110, the trader will face losses on the call side. For instance, if
the price reaches Rs.120, the loss would be Rs.10 per share (Rs.120 – Rs.110),
but this would be offset slightly by the Rs.5 premium received, resulting in a
Rs.5 net loss per share.
If the price drops below Rs.90, the trader will lose on the
put side. For instance, if the price falls to Rs.80, the loss would be Rs.10
per share (Rs.90 – Rs.80), offset by the Rs.5 premium, resulting in a Rs.5 net
loss per share.
6. When to use a
short strangle
A short strangle
strategy is suitable when a trader expects that the underlying asset will trade
within a range and remain relatively stable without large movements in either
direction. It’s ideal in periods of low volatility or when the trader expects
volatility to decrease. Since the strategy benefits from time decay (as the
value of options decreases over time), the goal is to allow the options to
expire worthless, thus retaining the premiums received.
7. Risks and considerations
Volatility risk: If volatility increases unexpectedly, the
price of both the call and put options could increase, leading to potential
losses even before the price of the underlying asset moves outside the strike
prices.
Unlimited risk: While the potential profit is limited to the
premiums received, the potential loss is theoretically unlimited on the call side,
especially if the stock makes a significant upward move.
Margin requirements: A short strangle typically requires a
substantial margin because of the significant risk of loss if the underlying
asset moves dramatically. This strategy is typically used by experienced
traders who have a large amount of capital available to cover potential losses.
8. Alternatives to
the short strangle
Traders who want to
cap their risk while using a similar strategy may consider a short iron condor,
which adds a long call and a long put to the short strangle to create defined
risk limits. The iron condor reduces potential profit but protects against unlimited
losses.
Conclusion
The short strangle
strategy can be highly profitable in a stable market but carries significant
risk if the market moves unexpectedly. It’s an advanced strategy that requires
careful monitoring and should only be used by experienced traders who
understand the risks involved. Traders employing this strategy should also be
prepared to take action if the price of the underlying asset approaches the
strike prices, such as adjusting the position to limit losses.
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