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.
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.