A short strangle is an options strategy made up of a short call at a higher strike price and a short put at a lower strike price. The contracts are on the same stock and for the same expiration date. It is set up for a new profit and is a profitable trade if the stock price remains between two strike prices. It has a significant potential for loss should the stock price falls below the lower strike price and is virtually unlimited should the stock price rise substantially above the upper price. Thus, this trade needs to be watched carefully by the trade who needs to quickly exit the trade if and when the stock becomes very volatile and threatens to break out of its profit range.
What Is a Strangle?
A strangle is an options strategy that includes a call and a put for the same stock and same expiration date but for different strike prices. A long strangle uses a purchased call and a purchased put. It differs from a long straddle in that the strike prices are spaced apart making it less expensive to set up but likely to gain a profit only if the stock moves farther from its starting point. The point of a long strangle is to profit from volatility. On the other hand, a short strangle is set up by selling two puts which are spaced apart for the same stock with the same expiration date. It profits when the stock price does not move outside of the price range defined by the two strike prices. The farther apart the two strike prices the less profit is gained from the trade but the safer it will be.
How Do You Hedge a Short Strangle?
There are two ways to hedge your risk with a short strangle option strategy. The first, when setting up the trade is to assess the likely degree of volatility of the stock. If you are concerned that unexpected price movement will result in losses, you can sell your puts at greater distances from the current stock price. This will give you more breathing room should unexpected movement occur. However, by selling puts at strike prices that are farther from the current stock price you will be lowering your potential profit. An alternative approach is to protect yourself in the direction in which you expect the most risk. This means either buying a call somewhat above your higher strangle strike price or a put somewhat below your lower strangle strike price. Either of these purchases will cut into your potential profit but protect you from potentially catastrophic losses.
When Should I Exit a Short Strangle?
The time to exit a short strangle is when unexpected volatility raises its head and not after the volatility has driven the stock price well beyond the strike price range of your short strangle. If the price does move quickly beyond your range of profit the decision of exiting or not will probably be taken away from you as the purchaser of either your call or put will likely exercise their option to buy or sell and you will be forced to comply with the terms of the option contract
Pros and Cons Of a Short Strangle
This can be a nice, profitable strategy in a quiet market. As with simply selling a call or a put, you collect a premium for taking on the risk that the stock price will move away from its current trading range. Unlike with just a call or just a put, you are taking on risk in both directions in return for a higher potential profit. The down side of this strategy is that unless you set it up well or hedge it, the potential loss could be substantial. When working with Top Gun Options you will be able to learn when to use this strategy and how to most effectively set it up.