Tasty Tidbit | The Strangle Checklist

Oct 1, 2015

By: Sage Anderson

Effective portfolio management hinges around prudent decision-making.

There are tens of thousands of different trades that can be executed on any given day and a critical factor is filtering this universe down to the select few opportunities that best meet your personal investment goals and time horizon.

If you have decided that a short strangle is an ideal fit for current market conditions, then a recent episode of Market Measures is right up your alley.

A short strangle involves selling a call and a put from the same expiration cycle with different strike prices. Typically, a strangle involves selling out-of-the-money options. However, selling in-the-money options can also be executed through a strangle (called a guts strangle).

On this particular episode of Market Measures, hosts Tom Sosnoff and Tony Battista guide viewers through a mental checklist for selling strangles.

The intent here is to highlight some of the most important things to consider when entering a short strangle position. Going through the checklist not only helps ensure that key factors are being considered, but it may also raise red flags which assist in avoiding bad trades.
The six main points that Tom and Tony discuss are listed on the slide below:

The first line on the slide above highlights the preferred 45 days-to-expiration that tastytrade research has shown can be an optimal duration for options trading strategies.

The second point refers to potential news that may affect the underlying. Of course, short strangles and short straddles perform the worst when stocks make violent moves prior to the expiration of a position.

It can be helpful, therefore, to initiate such positions in symbols that a trader knows well from a news standpoint. For example, if a company is facing litigation that may significantly affect their earnings, then a trader may want to steer clear of short premium positions in that particular underlying.

Having traded thousands of short strangles and straddles in the past, I can say with great confidence that it is also beneficial to stick with companies that possess large market capitalization when considering a short premium strangle. Not only are the options in these companies sufficiently liquid, but the size of the company's financial resources helps insulate it from unexpected, negative news.

During the show, Tom and Tony discuss some of the typical news and corporate action categories that traders should be aware of - as depicted below:

The next important factor that is discussed on Market Measures involves the implied volatility of the options in the stock you are considering. Obviously, it is preferable to sell premium in options that possess a high implied volatility rank (IVR). This is a measure developed at tastytrade which ranks an option’s implied volatility as compared to the last 52 weeks of trading.

An IVR close to 100% would indicate that implied volatility is near the highest levels, while an IVR closer to 0% would indicate implied volatility is at the lows of the year. For example, if XYZ has had an implied volatility between 30 and 60 over the past year and implied volatility is currently at 45, XYZ would have an IV rank of 50%.

It's important to remember that a sky-high IVR may be related to pending news - meaning that IVR shouldn't be the sole determining factor in the decision-making process.

The next item on the checklist involves directional bias. As a strangle is most profitable if an underlying settles exactly between the strikes at expiration, then ideally you will have a neutral view of the stock and the broader market when initiating a short strangle.

Lastly, Tom and Tony raise the topic of trade management. In the past, tastytrade has featured extensive research that shows managing trades to 50% of maximum profit can help optimize return on capital.

Generally speaking, tastytrade research shows that the average profit per day from a position such as a short strangle will be larger during the first half of the trade's existence. With diminishing returns in the latter half, this would suggest that capital can be put to better use through redeployment in another position.

We encourage you to watch the entire episode covering strangle checklists on Market Measures when your schedule allows.

Additional information on managing winners and IV rank can be found on tastytrade.com at the following links:

As always, we appreciate any and all feedback at support@tastytrade.com and thank you for being a part of the tastytrade community!

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

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