A short strangle consists of selling a put and call at or near the outside range of a stock’s expected move. Think of it like a football team defending the red zone at each end of the field. The offense (stock) can do whatever it wants in the middle of the field, just so long as the twenty-yard line is not breached (in case it was not clear, the short put and short call represent the defense in this metaphor). To understand the risk of both short options being touched, we turn to POT (or probability of touch).
Probabilities are determined using implied vol and the normal distribution. Probability of expiring tells us the likelihood of an option being in-the-money (PITM) at expiration. And we can estimate the POT by multiplying an option’s prob of being ITM by two. For example, an option with 30% prob of ITM has a 2 x 30% = 60% prob of the stock touching that strike price between now and expiration.
Calculating POT for both strikes of a strangle simply involves taking the POT for each short option and multiplying them together. If a strangle is opened by selling a .30 PITM call and .30 PITM put, the POT for both sides looks like this:
POT = (.30 x 2) x (.30 x 2)
= .36 or 36%
This means there is a 36% probability of both short strikes being touched between the current day and expiration. Widening out strangles will lower POT and reduce risk. For instance, a strangle using .16 delta options only has a 10% POT for both sides.
Selling strangles is a common premium selling strategy. However, when a short strike is touched, traders may become nervous. While it is very rare for both short strikes to be touched, understanding POT before entering a trade helps determine risk and where to place short strikes.
Josh Fabian has been trading futures and derivatives for more than 25 years.
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