As an investor in a financial market, one must keep an open mind and strive to learn more about strategies that make the most of market conditions – even during periods of low volatility. Whether you are a new or a seasoned options trader, a useful strategy that might be worth knowing about is the short strangle option strategy that benefits from range-bound price action. Read on to know more about the short strangle:
How are Options Traded?
Before we delve into the question of ‘what is short strangle’ and how the strategy is implemented, let us establish context by reviewing the concept of options trading. Options fall under the category of derivatives, a type of financial instrument that derives its value from an underlying asset.
Trading in options is done by the means of contracts that stipulate that the buyer has a right but not an obligation to buy or sell an asset before a predetermined date, at a given price. This is known as the strike price. Meanwhile, the options that provide for the purchase of assets are known as call options while those that allow the sale of assets are known as put options. These concepts are essential to understanding how the short strangle option strategy works.
What is the Short Strangle Strategy?
In the context of options trading as explained above, a short strangle strategy is a neutral strategy and allows an investor to benefit from the status quo in a financial market. A short strangle position is held when an investor simultaneously sells a slightly out-of-the-money call option as well as an out-of-the-money put option of the same underlying asset with the same expiration date. However, the strike prices for both are different.
As the short strangle strategy deals with the selling of options, it is also often referred to as the sell strangle. The sell strangle option is ideal for when an options trader believes that the market will experience very little to no volatility in near future. With the short strangle, the trader simply counts on the possibility that as time passes, the value of the underlying asset will continue to remain between the two short strike prices.
How the Short Strangle Strategy Works
The short strangle is a strategy with limited profit potential. The opportunity for maximum profit in a short strangle strategy arises if on the expiration date, the value of the underlying asset is between the strike prices of the strangle. In such a case, the maximum profit earned by the investor is the difference between the net premium paid and the commissions paid.
However, the short strangle strategy also comes with unlimited risk potential. The investor can experience a large loss in the event that the underlying asset experiences either a sharp rise or fall in price.
If the price of the asset ends up higher than the call strike, the put option expires and results in net premium, but the call option comes into effect and results in loss. Meanwhile, if the price of the asset ends up lower than the put strike, the call option expires and results in net premium, but the put option is exercised and leads to loss. Either way, the short strangle can lead to unlimited loss if the strike prices are not set with caution.
Advantages and Disadvantages of Short Strangle Strategy
The short strangle strategy is an advanced options trading strategy that involves simultaneously selling an out-of-the-money (OTM) put option and an OTM call option with the same expiration date. Traders use this strategy to profit from low volatility and range-bound markets. However, like any option trading strategy short strangle comes with its own set of advantages and disadvantages such as the following:
- Income generation: The premium collected during the short struggle strategy lets you generate income, especially in quiet or sideways markets.
- Range-bound profit: Short strangles are suitable during phases of low volatility and a limited price range. If the underlying asset price continues to stay within the strike prices of the options sold, the trader can keep the premium as a profit.
- Statistical edge: The options sold in short strangle are out-of-the-market contracts. Hence, there’s a statistically higher chance that they will expire worthless, leading to a profitable outcome for the trader.
- Defined risk: The risk in a short strangle is limited to the difference between the strike prices of the options minus the premium received. This limited risk is known upfront and can be managed effectively.
On the downside of short strangles, you need to remember the following:
- Unlimited loss: If the underlying asset makes a significant move beyond the sold call or put strike price, losses can accumulate quickly.
- Higher margin: Brokers often require traders to maintain a significant margin when engaging in short strangle positions due to the unlimited loss potential.
- Transaction costs: Frequent trading of multiple options contracts can lead to higher commissions and fees, and reduce potential profits.
- Volatility exposure: If the underlying asset experiences a sharp and unexpected price movement, it can result in significant losses.
- Continuous monitoring requirements: Traders employing short strangles must actively monitor their positions and be prepared to make adjustments or exit the trade if the market moves against them. This requires time and attention.
Types of Strangles
There are two major types of strangles – long and short.
- Long strangle: A long strangle allows investors to make a profit when the market is volatile and is expected to move in either direction. The investor simultaneously buys an out-of-money call and an out-of-money put, where the call option’s strike price is higher than the market price of the asset and the put option’s strike price is lower than the market price of the underlying stock.
- Short strangle: A short strangle is a preferred strategy during low market volatility and when the asset price moves in a range. It involves simultaneously selling an OTM call and an OTM put at a different strike price. The strike price of the call option is higher than the current market price of the underlying asset and the strike price of the put option is lower than the market price of the underlying asset.
Components of a Short Strangle
- Selling an OTM call and an OTM put: The major part of the strangle involves selling an OTM call and an OTM put. In a strong strangle, the trader believes the underlying security will move in a range, between the strike prices of the call and put options.
- Same expiration date: Both the call and put options have the same expiration date. This ensures that the short strangle strategy is executed as a single position and that the trader’s obligations on both options align.
- Premium collection: The trader collects premiums from selling both call and put options. These premiums represent the immediate income received when the options are sold.
- Strike Price Differential: The success of a short strangle largely depends on the strike price differential between the call and put options. The wider the strike price differential, the greater the potential profit and risk.
- Limited profit, unlimited risk: The maximum profit in a short strangle is limited to the combined premiums received for selling both the call and put options. However, the risk of a short strangle is theoretically unlimited if the asset price makes a significant movement.
How Risky Is a Short Strangle?
A short strangle is a good strategy when it is unclear which direction the market will move. However, investors must appraise themselves of the set of risks associated with the strategy, which are:
- Unlimited risk potential: The primary reason a short strangle is considered risky is because of its unlimited risk potential on one side. While the maximum profit is limited to the premiums received when selling the call and put options, the potential loss is theoretically unlimited.
- Market volatility: High volatility in the underlying asset can increase the risk of a short strangle.
- Strike Price Selection: The choice of strike prices is crucial to managing risk. A wider differential between the call and put strike prices increases potential profit but also exposes the trader to greater risk.
- High margin requirement: Brokers often require traders to maintain a significant margin when engaging in short strangle positions due to the unlimited loss potential.
Which Is Better, Short Strangle or Straddle?
Deciding between a Short Strangle and a Straddle strategy depends on market conditions, volatility expectations, and the trader’s risk tolerance. Each strategy has its own advantages and disadvantages.
The straddle is useful when the trader is unsure in which direction the share price might move. The strategy allows traders to protect their positions regardless of market movement. Conversely, a strangle is useful when the trader thinks the security price will move in one direction but just wants to be protected from an unfavourable movement.
Tips for Short Strangle Strategy
With the unlimited risk potential that accompanies the short strangle option strategy, it is important for an options investor to keep in mind certain considerations before taking the position:
- The short strangle option strategy is ideal for circumstances where the market forecast is fairly neutral and there is only a possibility for limited action in the market. For example, an appropriate opportunity for the short strangle is the intermediary period between major events or announcements that are certain to cause major price fluctuations.
- Another good opportunity for the short strangle strategy is when the trader feels that the options are overvalued and the predicted volatility seems on the higher end. It gives the investor a chance to profit from the price correction.
- The investor should also ensure that the time frame to the expiration date remains short, with 1 month being the maximum, to make the most of time decay.
The short strangle strategy allows investors to make the most of low-volatility periods in the market. When the right assets are selected and the strike prices are chosen wisely, the short strangle strategy can be a beneficial strategy in the periods between big price-fluctuating announcements. However, as with all strategies, an investor must proceed at his or her own discretion to ensure the best possible outcome.