Short Strangle Options Strategy: Definition, Implementation, And Profit

What Is A Short Strangle?

Short Strangle is an options trading strategy that involves one out-of-the-money short call option and one short out-of-the-money put option. Both the options contracts should be of the same underlying asset and expiration date, but with different strike prices.

The short strangle options strategy is an improvised version of the short straddle options strategy that helps in the reduction of the strategy cost, but with an increase in breakeven point.

Construction of Short Strangle Options Strategy

To create the short strangle options trading strategy you need to follow these steps;

  1. Sell one out-of-the-money call option to receive the premium.
  2. Sell one out-of-the-money put option to receive the premium.

Understanding The Short Strangle Options Strategy

A short strangle options strategy consists of one short call option with a higher strike price and one short put option with a lower strike. Both option contacts have the same stock and expiration date, the only difference is their strike prices. 

The short strangle options strategy is built for a net receipt and the trader makes profits when the underlying security trades in a very narrow range between the two strike prices. The profit potential in this strategy is limited to the total premiums paid while selling the call and put options. The potential loss is unlimited on both upside and downside movement below or higher than the strike prices.

This options strategy is sensitive to the implied volatility, and even if the stock price stays constant, a sharp rise in implied volatility of the overall market would push up the value of both call and put options and force the trader to inject additional margin in order to maintain the short positions.

Short Stangle Options Strategy Profit and Loss

The short strangle options trading strategy is a limited profit, infinite risk options strategy that is created when the trader thinks that the underlying asset will be neutral to a little volatile the near term. Short strangles options are credit spreads as a net credit is taken while entering the trade.

short strangle options strategy diagram

Maximum Profit

  • Maximum Profit = Net Premium Received – Commissions

Maximum profit for the short strangle options achieved when the underlying security price stays flat to little volatile till expiration date that means the security should trade between the strike prices of the options sold. In that price, both the call and put options will expire worthlessly and the options trader will keep the entire premium as profit.

Maximum Loss

  • Maximum Loss = Unlimited

Theoretically, the maximum loss in this strategy is unlimited and the large losses for the short strangle options strategy occurs when the underlying security price makes a significant movement in either upwards or downwards at the expiration date.

Breakeven

  • Upper Breakeven Price = Strike Price of Short Call + Net Premium Received
  • Lower Breakeven Price = Strike Price of Short Put – Net Premium Received

This options strategy breaks even if, on expiration, the stock price moves either above the call option strike price or below the put option strike price by the amount of premium received while creating a short options position. Using above the two formula you can calculate the breakeven price for the short strangle options strategy.

Example

Suppose a stock is trading at $100 in July contract (contract size: 100) and an options trader executes a short strangle options strategy by selling a JUL 90 put for $3 and a JUL 110 call for $3. So the total premium received by the options trader is $6 x100 = $600 (Contract size = 100) which is the maximum profit that options trader will get.

If the stock price rallied to $120, then the trader will suffer a loss of $10 – $6 = $4 x 100 = $400, and the same loss will happen if the stock price falls to $80 at expiration and the loss increases with the further downside.

In another scenario, if the stock expires at $105, then both the call option and the put option will expire worthlessly and the options trader will get the maximum profit of $600.

Limitations

The only limitation to the short strangle options strategy is that this strategy has unlimited loss potential in highly volatile market conditions and with just limited profit potential.

Key Takeaways

  • The maximum profit in this strategy is limited to the net premium received by the options trader.
  • The maximum loss in this strategy is unlimed.
  • Maximum profit realized when the underlying asset price is in between the strike price of both the short call and short put.
  • A Loss happens when the underlying asset price is greater than the strike price of short call option plus the net premium received or the underlying asset price is less than the strike price of short put option minus the net premium received.

Conclusion

By selling two option contracts, the risk in this strategy increases significantly with an increase in implied volatility. The strategy has unlimited risk on the substantial upside and downside movement on the stock price. To avoid the risk you should consider the iron condor or iron butterfly options trading strategy.

Video Source: Projectoption

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