Short Strangle

Introduction

Based on your research, you believe the stock you are interested in is going to trade within a narrow range well into the future. You are looking to express your opinion that the stock’s volatility will decrease.

Utilizing your foundational knowledge of short call and short put positions, you decide to sell both a call and a put. You realize that you have a greater likelihood of maximizing your gains if you choose a variation on a straddle by instead selecting a higher strike call and a lower strike put.

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What exactly is a Short Strangle?

A short strangle consists of one short call and one short put. The options must have the same underlying security, the same expiration date, and different strike prices (higher strike call, lower strike put) for the strategy to be referred to as a strangle.

A short strangle is established for a net credit because you collect premiums from selling the options.

This strategy exposes you to the risks and benefits of short options. The short call has unlimited upside risk exposure while the short put has significant but capped risk exposure on the downside. The maximum gain for the short strangle is the total net premium collected for the call and the put.

Short Strangle Strategy: Additional Observations

A short strangle may be the strategy of choice when the forecast is for neutral, or range-bound, price action. Strangles are often sold between earnings reports and other publicized announcements that have the potential to cause sharp stock price fluctuations.

It is important to remember that the price of calls and puts – and therefore the price of strangles – contains the collective opinion of options market participants on how much the stock price will move prior to expiration. This means that sellers of strangles believe that the market consensus is “too high” and that the underlying security price will stay between the breakeven points.

“Selling a strangle” is intuitively appealing because you can collect two option premiums and the stock price must move quite a bit before you lose money. The reality is that the market is often “efficient,” which means that strangle prices are frequently an accurate gauge of how much a stock price is likely to move prior to expiration. Selling a strangle, like all trading decisions, is subjective and requires good timing for both entering the position and exiting or selling out of it.

The Straddle vs. Strangle Debate

Short strangles are often compared to short straddles, with traders frequently debating which strategy is “better.”

Short strangles involve selling a call with a higher strike price and selling a put with a lower strike price and the same expiry. For example, sell a January 105 call and sell a January 95 put on XYZ stock. Short straddles, however, involve selling a call and put with the same strike price and expiry on the same underlying asset. For example, sell a January 100 call and sell a January 100 put on XYZ stock.

Neither strategy is “better” in an absolute sense – each has unique trade-offs.

There are three advantages of a short strangle:

• The breakeven points for a short strangle are further apart than for a comparable straddle.
• There is a greater chance of keeping 100% of the premiums received if a short strangle is held to expiration.
• Short strangles are more sensitive to time decay than short straddles. Thus, when there is little or no stock price movement, a short strangle will experience a greater percentage profit over a given time period than a comparable short straddle.

There is one disadvantage of a short strangle:

• The premiums received and maximum profit potential for selling one strangle are lower than for one straddle.

Example

• Sell 10 January XYZ 45 puts for $0.65
• Sell 10 January XYZ 50 calls for $0.60

In our example, assume stock XYZ is currently trading at $47.50. We sell 10 January XYZ 50 calls for a total of $600 (10 x 100 multiplier x $0.60), less commissions and fees, and simultaneously sell 10 January XYZ 45 puts for a total of $650 (10 x 100 multiplier x $0.65), less commissions and fees.

As a result of these two simultaneous trades, our account has a credit balance of approximately $1,250 (excluding commissions and fees).

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Outcome 1: Profit

With a short strangle position, you are committing to volatility decreasing. This means your sentiment is neutral, believing that the stock price will hover with the price range of the strikes.

Let’s assume we are correct in our sentiment, and the stock price does not move. To calculate our profit at expiration on the position, use the following formula:

Profit = Net Profit/Loss from the Short Call + Net Profit/Loss from the Short Put

For the Short Call,

if S – K > 0, then the Loss = – (Current Stock Price – Strike Price) + Net Premium Received

= – Current Stock Price + Strike Price + Net Premium Received

if S – K < 0, then the Profit = Net Premium Received

For the Short Put,

if K – S > 0, then the Loss = – (Strike Price – Current Stock Price) + Net Premium Received

= – Strike Price + Current Stock Price + Net Premium Received

if K – S < 0, then the Profit = Net Premium Received

Max Profit = Total Net Premiums Received

Example

Stock XYZ is trading at $47.50 and you establish a short strangle position.

• Sell 10 January XYZ 45 puts for $0.65
• Sell 10 January XYZ 50 calls for $0.60

A week later, stock XYZ is trading at $48.

*Unrealized profits/losses are those that potentially exist; realized profits/losses occur when you close out or trade out of the position.

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Outcome 2: Loss

Let’s assume the market fluctuates wildly and we are incorrect about our forecast of volatility decreasing. To calculate our loss on the position, use the following formula:

Loss = Net Profit/Loss from the Short Call + Net Profit/Loss from the Short Put

For the Short Call,

if S–K > 0, then the Loss = – (Current Stock Price – Strike Price) + Net Premium Received

= – Current Stock Price + Strike Price + Net Premium Received

if S–K < 0, then the Profit = Net Premium Received

For the Short Put,

if K–S > 0, then the Loss = – (Strike Price – Current Stock Price) + Net Premium Received

= – Strike Price + Current Stock Price + Net Premium Received

if K–S < 0, then the Profit = Net Premium Received

Max Loss = Unlimited (upside); Significant though capped (downside)

Example

Stock XYZ is trading at $47.50 and you establish a short strangle position.

• Sell 10 January XYZ 45 puts for $0.65
• Sell 10 January XYZ 50 calls for $0.60

A week later, stock XYZ is trading higher at $65.

*Unrealized profits/losses are those that potentially exist; realized profits/losses occur when you close out or trade out of the position.

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Outcome 3: Breakeven

There are two potential breakeven points for the short strangle:

• Call strike plus net premiums received
• Put strike minus net premiums received

Upside Breakeven Price = Call Strike Price + Net Premiums Received

Downside Breakeven Price = Put Strike Price – Net Premiums Received

Example

Stock XYZ is trading at $47.50 and you establish a short strangle position.

• Buy 10 January XYZ 45 puts for $0.65
• Buy 10 January XYZ 50 calls for $0.60
• Fees and commissions = $20 total or $0.20 per share

Strangle Upside Breakeven Price = $50 + ($1.25 + $0.20) = $51.45

Strangle Downside Breakeven Price = $45 – ($1.25 + $0.20) = $43.55

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At-A-Glance

Strategy

• Short Strangle

Alternative Name

• n/a

Pre-Requisite Strategy Knowledge

• Short Call
• Short Put

Legs of Trade

• 2 legs

Sentiment

• Neutral

Example

• Short 10 Jan XYZ 45 puts
• Short 10 Jan XYZ 50 calls

Rule to Remember

• The short put and short call must have the same underlying, same expiration, but different strikes (higher call strike, lower put strike).

Max Potential Profit (GAIN)

• Total Premiums Received

Break-Even Points

At expiration, there are two potential breakeven points:

• Upside breakeven = Call strike plus net premiums received for the strangle
• Downside breakeven = Put strike minus net premiums received for the strangle

Max Potential Risk (LOSS)

• Unlimited (upside); Significant though capped (downside)

Ideal Outcome

• XYZ price remains with the range of the put strike price and the call strike price

Early Assignment Risk

American options can be exercised on any business day, and the holder of a short option position has no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment must be considered when entering positions involving short options. Early assignment of options is generally related to dividends, and short calls that are assigned early are generally assigned on the day before the ex-dividend date. In-the-money calls whose time value is less than the dividend have a high likelihood of being assigned.

The short strangle strategy has early assignment risk.

Short calls that are assigned early are generally assigned on the day before the ex-dividend date. Therefore, if the stock price is above the strike price of the short strangle, an assessment must be made if early assignment is likely. If assignment is deemed likely and if a short stock position is not wanted, then appropriate action must be taken before assignment occurs (either buying the short call and keeping the short put open or closing the entire strangle).

Short puts that are assigned early are generally assigned on the ex-dividend date. Therefore, if the stock price is below the strike price of the short strangle, an assessment must be made if early assignment is likely. If assignment is deemed likely and if a long stock position is not wanted, then appropriate action must be taken before assignment occurs (either buying the short put and keeping the short call open or closing the entire strangle).

If early assignment of a stock option does occur, then stock is purchased (short put) or sold (short call). If no offsetting stock position exists, then a stock position is created. If the stock position is not wanted, it can be closed in the marketplace by taking appropriate action (selling or buying). Note, however, that the date of the closing stock transaction will be one day later than the date of the opening stock transaction (from assignment). This one-day difference will result in additional fees, including interest charges and commissions. Assignment of a short option might also trigger a margin call if there is not sufficient account equity to support the stock position.

Potential Position Created at Expiration:

There are three possible outcomes at expiration: the stock price can be at a strike price or between the strike prices of a short strangle, above the strike price of the call (the higher strike), or below the strike price of the put (the lower strike).

• If the stock price is at a strike price or between the strike prices at expiration, then both the call and the put expire worthless and no stock position is created.
• If the stock price is above the strike price of the call (the higher strike) at expiration, the put expires worthless, the short call is assigned, stock is sold at the strike price and a short stock position is created. If a short stock position is not wanted, the short call must be closed (purchased) prior to expiration.
• If the stock price is below the strike price of the put (lower strike) at expiration, the call expires worthless, the short put is assigned, stock is purchased at the strike price and a long stock position is created. If a long stock position is not wanted, the put must be closed (purchased) prior to expiration.

Note: options are automatically exercised at expiration if they are one cent ($0.01) in the money. Therefore, if the stock price is “close” to one of the strike prices of a short strangle as expiration approaches, and if the holder of a short strangle wants to avoid having a stock position, the short option in danger of being assigned must be closed (purchased) prior to expiration.

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