Ultimate Guide To The Short Strangle Strategy

A short straddle is an advanced options strategy used where a trader would sell a call and a put with the following conditions:

  1. Both options must use the same underlying stock
  2. Both options must have the same expiration
  3. Both call and put options are out of the money (OTM).

short strangle is established for a net credit and profits if the underlying stock trades in a narrow range between the break-even points. The profit potential is limited to the total premium received minus commissions.

Since selling a short strangle involves selling both a call and a put, the trader gets to collect two premiums up-front, something that makes selling strangles appealing although, there are risks associated with this trade.

A short strangle can result in unlimited loss potential whenever a substantial move occurs so this strategy should be used with caution, particularly around significant market events like an earnings announcement.

Losses in the trade accumulate if the underlying stock makes a substantial move beyond the breakeven points to either the downside or the upside, which can result in unlimited losses.

Selling short strangles is a strategy generally used when the market is experiencing low volatility and no events are expected before the expiration date.

Below we illustrate an example of how a short strangle looks.  We are going to use the example below in the next few sections.

This is a SPY short strangle from September 18th, 2020:

Maximum Loss

Maximum loss is unlimited on the upside because the stock price can rise indefinitely. On the downside, the maximum loss is limited, but only to the extent that the stock price can only fall to zero.

Short strangles involve selling naked options and are not recommended for beginners.

In the example illustrated above, the trader received $446 in premium for selling the out-the-money call and out-the-money put.

Let us assume SPY drops 20%, SPY would trade at $268.50.

The 355 call would expire worthless and the 307 puts would be in-the-money and the loss on this leg would be (307-268.5) x 100 = $3850

Subtracting the credit received, we get a total potential loss on the downside of $3404.

As you can see when things go wrong with this strategy, they can go really wrong, so short strangles should be used with caution and a stop loss should be used.

The loss potential on the upside is theoretically unlimited. Wherever the stock finishes, take the ending price, less the call strike price x 100, and add back the premium.

Maximum Gain

The maximum gain occurs when the underlying stock price is trading between the strike prices of the put and call option when the expiration date is reached.

When this occurs, the call and put options will expire worthless and the gain is equal to the credit received when entering the position.

Using our SPY example, the maximum gain is $446 and would occur if SPY closed between $307 and $355 on expiration.

In reality, most traders will close out their position well before expiry.

We will talk about profit targets and stop losses in one of the sections below.

Breakeven Price

A short strangle has two breakeven prices, which can be found by applying the following formulas:

Upper Breakeven Price = Strike Price of the Short Call + Net Premium Paid

Lower Breakeven Price = Strike Price of the Short Put – Net Premium Paid

In our SPY example, we can calculate the breakeven prices as $302.54 and $359.5.46

Payoff Diagram

Short strangles have a payoff diagram shown with a dashed line in the graph of the SPY trade.  The trade has high gamma, particularly when it approaches expiration.

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Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are ...

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