Short Strangle Option Strategy
What is a Short Strangle Option?
Options strangles can be split into two different configurations, a Long Strangle option and a Short Strangle option. We’re going to explain the Short Strangle Option strategy and what is required should you choose to employ this useful strategy.
The Short Strangle Option
This is essentially the opposite of the long strangle. With a long strangle you are looking at a rise in volatility in the underlying asset in either direction, a short strangle is looking for little movement in the underlying asset to profit.
This can be classed as a neutral strategy and profits when the underlying price stays between the two strike prices as time passes. An investor is looking for time decay here or a decrease in implied volatility so an ideal time to deploy this strategy would be during a high implied volatility environment.
SHORT STRANGLE EXAMPLE
We explain the different intricacies of the short strangle option strategy with an example below:
XYZ PLC stock is trading at 405. An options trader executes a short strangle by selling a 380 put at 12 and a 420 call at 15. The net credit taken to enter the trade is the maximum possible profit (27).
If XYZ PLC stock rises and is trading at say 500 on expiry, the 380 puts will expire worthless but the 420 calls expire in-the-money and have an intrinsic value of 80 thus creating a loss of 53 (80-27) The same will happen if, for example, the stock was trading at 300 but with the 380 puts having an intrinsic value of 80.
On expiration, if XYZ stock is trading between 380 and 420, both the 380 put and the 420 call expire worthless and the options trader gains the maximum profit of 27 which is the initial credit they received when opening the strategy.
Short Strangle Pay-Off Diagram
The short strangle strategy is a limited profit, unlimited risk options trading strategy that is taken when the options trader thinks that the stock will experience little volatility in the short term. Short strangles are also known as credit spreads as a net credit is taken in when entering the trade.
Short Strangle Summary
- Sell a put with a strike price below the current market price of the underlying.
- Sell a call with a strike price above the current market price of the underlying.
- Anticipates decreased volatility – You think a period of low volatility is coming and have a neutral view.
- The underlying price of the asset is to be in the middle of the two strikes you have sold so that the options can expire worthless.
PROS OF THE SHORT STRANGLE
- Premiums can be very attractive.
- High-time decay in a neutral market.
CONS OF THE SHORT STRANGLE
- Higher risk strategy
- Beware of high margins.
- Potential losses can accumulate very quickly.
- Assignment risks on both options if they are American style.