Short Strangle (Sell Strangle) Explained

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Short Strangle (Sell Strangle)

The short strangle, also known as sell strangle, is a neutral strategy in options trading that involve the simultaneous selling of a slightly out-of-the-money put and a slightly out-of-the-money call of the same underlying stock and expiration date.

Short Strangle Construction
Sell 1 OTM Call
Sell 1 OTM Put

The short strangle option strategy is a limited profit, unlimited risk options trading strategy that is taken when the options trader thinks that the underlying stock will experience little volatility in the near term. Short strangles are credit spreads as a net credit is taken to enter the trade.

Limited Profit

Maximum profit for the short strangle occurs when the underlying stock price on expiration date is trading between the strike prices of the options sold. At this price, both options expire worthless and the options trader gets to keep the entire initial credit taken as profit.

The formula for calculating maximum profit is given below:

  • Max Profit = Net Premium Received – Commissions Paid
  • Max Profit Achieved When Price of Underlying is in between the Strike Price of the Short Call and the Strike Price of the Short Put

Unlimited Risk

Large losses for the short strangle can be experienced when the underlying stock price makes a strong move either upwards or downwards at expiration.

The formula for calculating loss is given below:

  • Maximum Loss = Unlimited
  • Loss Occurs When Price of Underlying > Strike Price of Short Call + Net Premium Received OR Price of Underlying

Breakeven Point(s)

There are 2 break-even points for the short strangle position. The breakeven points can be calculated using the following formulae.

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

Example

Suppose XYZ stock is trading at $40 in June. An options trader executes a short strangle by selling a JUL 35 put for $100 and a JUL 45 call for $100. The net credit taken to enter the trade is $200, which is also his maximum possible profit.

If XYZ stock rallies and is trading at $50 on expiration in July, the JUL 35 put will expire worthless but the JUL 45 call expires in the money and has an intrinsic value of $500. Subtracting the initial credit of $200, the options trader’s loss comes to $300.

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On expiration in July, if XYZ stock is still trading at $40, both the JUL 35 put and the JUL 45 call expire worthless and the options trader gets to keep the entire initial credit of $200 taken to enter the trade as profit.

Note: While we have covered the use of this strategy with reference to stock options, the short strangle is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the short strangle in that they are also low volatility strategies that have limited profit potential and unlimited risk.

Short strangle

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To profit from little or no price movement in the underlying stock.

Explanation

Example of short strangle

Sell 1 XYZ 105 call at 1.50
Sell 1 XYZ 95 put at 1.30
Net credit = 2.80

A short strangle consists of one short call with a higher strike price and one short put with a lower strike. Both options have the same underlying stock and the same expiration date, but they have different strike prices. A short strangle is established for a net credit (or net receipt) and profits if the underlying stock trades in a narrow range between the break-even points. Profit potential is limited to the total premiums received less commissions. Potential loss is unlimited if the stock price rises and substantial if the stock price falls.

Maximum profit

Profit potential is limited to the total premiums received less commissions. The maximum profit is earned if the short strangle is held to expiration, the stock price closes at or between the strike prices and both options expire worthless.

Maximum risk

Potential loss is unlimited on the upside, because the stock price can rise indefinitely. On the downside, potential loss is substantial, because the stock price can fall to zero.

Breakeven stock price at expiration

There are two potential break-even points:

  1. Higher strike price plus total premium:
    In this example: 105.00 + 2.80 = 107.80
  2. Lower strike price minus total premium:
    In this example: 95.00 – 2.80 = 92.20

Profit/Loss diagram and table: short strangle

Short 1 105 call at 1.50
Short 1 95 put at 1.30
Net credit = 2.80
Stock Price at Expiration Short 105 Call Profit/(Loss) at Expiration Short 95 Put Profit/(Loss) at Expiration Short Strangle Profit / (Loss) at Expiration
110 (3.50) +1.30 (2.20)
109 (2.50) +1.30 (1.20)
108 (1.50) +1.30 (0.20)
107 (0.50) +1.30 +0.80
106 +0.50 +1.30 +1.80
105 +1.50 +1.30 +2.80
104 +1.50 +1.30 +2.80
103 +1.50 +1.30 +2.80
102 +1.50 +1.30 +2.80
101 +1.50 +1.30 +2.80
100 +1.50 +1.30 +2.80
99 +1.50 +1.30 +2.80
98 +1.50 +1.30 +2.80
97 +1.50 +1.30 +2.80
96 +1.50 +1.30 +2.80
95 +1.50 +1.30 +2.80
94 +1.50 +0.30 +1.80
93 +1.50 (0.70) +0.80
92 +1.50 (1.70) (0.20)
91 +1.50 (2.70) (1.20)
90 +1.50 (3.70) (2.20)

Appropriate market forecast

A short strangle profits when the price of the underlying stock trades in a narrow range between the breakeven points. The ideal forecast, therefore, is “neutral or sideways.” In the language of options, this is known as “low volatility.”

Strategy discussion

A short – or sold – strangle is 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 prices of calls and puts – and therefore the prices of strangles – contain the consensus opinion of options market participants as to 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 stock price will stay between the breakeven points.

“Selling a strangle” is intuitively appealing to some traders, because “you collect two option premiums, and the stock has to move ‘a lot’ before you lose money.” The reality is that the market is often “efficient,” which means that prices of strangles frequently are an accurate gauge of how much a stock price is likely to move prior to expiration. This means that selling a strangle, like all trading decisions, is subjective and requires good timing for both the sell (to open) decision and the buy (to close) decision.

Impact of stock price change

When the stock price is between the strike prices of the strangle, the negative delta of the short call and positive delta of the short put very nearly offset each other. Thus, for small changes in stock price between the strikes, the price of a strangle does not change very much. This means that a strangle has a “near-zero delta.” Delta estimates how much an option price will change as the stock price changes.

However, if the stock price “rises fast enough” or “falls fast enough,” then the strangle rises in price, and a short strangle loses money. This happens because, as the stock price rises, the short call rises in price more and loses more than the put makes by falling in price. Also, as the stock price falls, the short put rises in price more and loses more than the short call makes by falling in price. In the language of options, this is known as “negative gamma.” Gamma estimates how much the delta of a position changes as the stock price changes. Negative gamma means that the delta of a position changes in the opposite direction as the change in price of the underlying stock. As the stock price rises, the net delta of a short strangle becomes more and more negative, because the delta of the short call becomes more and more negative and the delta of the short put goes to zero. Similarly, as the stock price falls, the net delta of a short strangle becomes more and more positive, because the delta of the short put becomes more and more positive and the delta of the short call goes to zero.

Impact of change in volatility

Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices – and strangle prices – tend to rise if other factors such as stock price and time to expiration remain constant. Therefore, when volatility increases, short strangles increase in price and lose money. When volatility falls, short strangles decrease in price and make money. In the language of options, this is known as “negative vega.” Vega estimates how much an option price changes as the level of volatility changes and other factors are unchanged, and negative vega means that a position loses when volatility rises and profits when volatility falls.

Impact of time

The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion, or time decay. Since short strangles consist of two short options, the sensitivity to time erosion is higher than for single-option positions. Short strangles tend to make money rapidly as time passes and the stock price does not change.

Risk of early assignment

Stock options in the United States can be exercised on any business day, and the holder of a short stock option position has no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options.

Both the short call and the short put in a short strangle have early assignment risk. Early assignment of stock options is generally related to dividends.

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. Therefore, if the stock price is above the strike price of the call in a 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. In-the-money puts whose time value is less than the dividend have a high likelihood of being assigned. Therefore, if the stock price is below the strike price of the put in a 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 be assigned must be closed (purchased) prior to expiration.

Other considerations

Short strangles are often compared to short straddles, and traders frequently debate which the “better” strategy is.

Long strangles involve buying a call with a higher strike price and buying a put with a lower strike price. For example, buy a 105 Call and buy a 95 Put. Long straddles, however, involve buying a call and put with the same strike price. For example, buy a 100 Call and buy a 100 Put.

Neither strategy is “better” in an absolute sense. There are tradeoffs.

There are three advantages and one disadvantage to a short strangle. The first advantage is that the breakeven points for a short strangle are further apart than for a comparable straddle. Second, there is a greater chance of making 100% of the premium received if a short strangle is held to expiration. Third, 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. The disadvantage is that the premium received and maximum profit potential for selling one strangle are lower than for one straddle.

A short straddle has one advantage and three disadvantages. The advantage of a short straddle is that the premium received and the maximum profit potential of one straddle (one call and one put) is greater than for one strangle. The first disadvantage is that the breakeven points are closer together for a straddle than for a comparable strangle. Second, there is a smaller chance that a straddle will make its maximum profit potential if it is held to expiration. Third, straddles are less sensitive to time decay than strangles. Thus, when there is little or no stock price movement, a short straddle will experience a lower percentage profit over a given time period than a comparable short strangle.

Short Strangle

The Strategy

A short strangle gives you the obligation to buy the stock at strike price A and the obligation to sell the stock at strike price B if the options are assigned. You are predicting the stock price will remain somewhere between strike A and strike B, and the options you sell will expire worthless.

By selling two options, you significantly increase the income you would have achieved from selling a put or a call alone. But that comes at a cost. You have unlimited risk on the upside and substantial downside risk. To avoid being exposed to such risk, you may wish to consider using an iron condor instead.

Like the short straddle, advanced traders might run this strategy to take advantage of a possible decrease in implied volatility. If implied volatility is abnormally high for no apparent reason, the call and put may be overvalued. After the sale, the idea is to wait for volatility to drop and close the position at a profit.

Options Guy’s Tip

You may wish to consider ensuring that strike A and strike B are one standard deviation or more away from the stock price at initiation. That will increase your probability of success. However, the further out-of-the-money the strike prices are, the lower the net credit received will be from this strategy.

The Setup

  • Sell a put, strike price A
  • Sell a call, strike price B
  • Generally, the stock price will be between strikes A and B

NOTE: Both options have the same expiration month.

Who Should Run It

NOTE: This strategy is only for the most advanced traders who like to live dangerously (and watch their accounts constantly).

When to Run It

You are anticipating minimal movement on the stock.

Break-even at Expiration

There are two break-even points:

  • Strike A minus the net credit received.
  • Strike B plus the net credit received.

The Sweet Spot

You want the stock at or between strikes A and B at expiration, so the options expire worthless.

Maximum Potential Profit

Potential profit is limited to the net credit received.

Maximum Potential Loss

If the stock goes up, your losses could be theoretically unlimited.

If the stock goes down, your losses may be substantial but limited to strike A minus the net credit received.

Ally Invest Margin Requirement

Margin requirement is the short call or short put requirement (whichever is greater), plus the premium received from the other side.

NOTE: The net credit received from establishing the short strangle may be applied to the initial margin requirement.

After this position is established, an ongoing maintenance margin requirement may apply. That means depending on how the underlying performs, an increase (or decrease) in the required margin is possible. Keep in mind this requirement is subject to change and is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.

As Time Goes By

For this strategy, time decay is your best friend. It works doubly in your favor, eroding the price of both options you sold. That means if you choose to close your position prior to expiration, it will be less expensive to buy it back.

Implied Volatility

After the strategy is established, you really want implied volatility to decrease. An increase in implied volatility is dangerous because it works doubly against you by increasing the price of both options you sold. That means if you wish to close your position prior to expiration, it will be more expensive to buy back those options.

An increase in implied volatility also suggests an increased possibility of a price swing, whereas you want the stock price to remain stable between strike A and strike B.

Check your strategy with Ally Invest tools

  • Use the Profit + Loss Calculator to establish break-even points, evaluate how your strategy might change as expiration approaches, and analyze the Option Greeks.
  • Use the Probability Calculator to verify that both the call and put you sell are about one standard deviation out-of-the-money.
  • Examine the stock’s Volatility Charts. If you’re doing this as a volatility strategy, you want to see implied volatility abnormally high compared with historic volatility.

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