Anatomy of a Short Strangle
May 2, 2018
If inflated options premiums have you considering the short side of the volatility coin, a recent episode of Best Practices may be right up your alley.
The focus of this episode is short strangles and the factors that contribute to P/L.
A strangle is constructed by trading two different options (a put and call) with different strikes, but in the same expiration period. When deploying a long strangle both options are purchased, while a short strangle involves selling both options.
The intensity of the risk profile of a given strangle is generally dictated by the delta of the options used in its construction. Higher delta options involve higher premiums, which means there's more at stake the closer one gets to at-the-money (ATM). At the same time, strikes further away from the current underlying price can also be breached, although with lower probability.
Generally speaking, strangle sellers are hoping that the underlying price remains between the two strikes of the strangle through expiration, and that implied volatility goes lower. A strangle buyer is hoping for the opposite.
The maximum gain for a strangle seller is the total credit received upon trade deployment, whereas the theoretical maximum loss is unlimited. On the flip side, the maximum theoretical gain for a strangle buyer is unlimited, while the maximum loss is limited to the total premium outlaid for the position.
Strike selection in strangles involves a balance between risk and reward, and should match your own unique risk thresholds. It’s important to keep in mind that as you get further from ATM, the potential reward (credit received) also decreases.
On Best Practices, the hosts discuss the three major factors that dictate the P/L of a strangle:
direction of implied volatility
underlying price movement
Depending on the position taken, strangle traders will be looking for certain behavior in the options and underlying stock, according to the bullets above.
For strangle sellers, a lack of movement in the underlying should unlock the power of time decay (aka theta collection). Muted movement in the underlying should also translate to decreasing implied volatility, although that’s not always the case.
On the other hand, a big move in the underlying theoretically benefits strangle buyers, especially if the price moves beyond one of the strikes. Increasing implied volatility can also benefit a long strangle, even if the underlying doesn’t move.
The slides below, excerpted from Best Practices, illustrate the mechanics of a short strangle, and the preferred routes to positive returns:
It should be added that the credit received from selling a short strangle will serve as a buffer to some degree, especially if the underlying price moves through one of the strikes. A short strangle will break even if the underlying price moves outside one of the strikes by the same amount as the credit received.
Using the example in the slides above, that means this particular short strangle will break even if the underlying price closes at $88.50 or $106.50. Anywhere inside that range represents a profit, and anywhere outside that range represents a loss.
We hope you’ll take the time to review the complete episode of Best Practices focusing on short strangles when your schedule allows. If you want to learn more about the potential pitfalls of short strangles we also recommend this installment of Market Measures.
If you have any outstanding questions about strangles, or any other trading-related topic, we hope you’ll leave a message in the space below, or reach out to us directly at firstname.lastname@example.org.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on tastyworks.com.
tastytrade is a trademark/servicemark owned by tastytrade.
tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”).
tastyworks, Inc. (“tastyworks”) has entered into a Marketing Agreement with tastytrade (“Marketing Agent”) whereby tastyworks pays compensation to Marketing Agent to recommend tastyworks’ brokerage services. The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of Marketing Agent by tastyworks. tastytrade is the parent company of tastyworks. tastyworks and Marketing Agent are separate entities with their own products and services. tastytrade has different privacy policies than tastyworks.
Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on quietfoundation.com is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.
Small Exchange, Inc. is a Designated Contract Market registered with the U.S. Commodity Futures Trading Commission. The information on this site should be considered general information and not in any case as a recommendation or advice concerning investment decisions. The reader itself is responsible for the risks associated with an investment decision based on the information stated in this material in light of his or her specific circumstances. The information on this website is for informational purposes only, and does not contend to address the financial objectives, situation, or specific needs of any individual investor. Trading in derivatives and other financial instruments involves risk, please read the Risk Disclosure Statement for Futures and Options. tastytrade is an investor in Small Exchange, Inc.