Short Strangle Options Strategy: Key features and set-up

What is Short Strangle Strategy?

A short strangle option strategy is like betting on your lazy cousin to stay put on the couch. You sell an out-of-the-money call and an out-of-the-money put, hoping the stock price doesn’t move much. This volatility strategy makes money from minimal stock movement, time decay, and falling volatility.

When to use a Short Strangle?

A short Strangle is a strangle strategy which involves selling an out-of-the-money short call and an out-of-the-money short put for the same expiration date, and is profitable if the price of the underlying asset stays within a certain range. Here’s when you can use a short strangle strategy:

1. Expecting Low Volatility: Use a short strangle when you believe the stock will trade within a relatively narrow range without any big price swings. This strategy profits from low volatility, as you’re betting that the stock price won’t move significantly in either direction before expiration.
2. Benefiting from Time Decay: If you’re looking to make use of time decay (theta), a short strangle can be effective. As time passes, the value of the options declines, allowing you to potentially buy them back at a lower price for a profit as expiration approaches.
3. High Implied Volatility: A short strangle can be ideal when implied volatility is high, as you can sell the options at a premium. When the volatility decreases, the options’ value also declines, potentially allowing you to profit if the stock price remains stable.

How to set up a Short Strangle?

1. Sell a call option above the current stock price.
2. Sell a put option below the current stock price, both with the same expiration date.

Example:

• Stock at ₹100.
• Sell a ₹105 call.
• Sell a ₹95 put.

The credit you get is your maximum profit. The risk is unlimited beyond the credit received if the stock price moves significantly up or down.

Payoff Diagram

Imagine an upside-down “U.” The maximum profit is the initial credit received. The maximum loss is undefined beyond the credit received.

Example:

• Initial Setup:
  • Stock is trading at ₹5,000.
  • Sell a ₹4,800 Put Option for ₹100.
  • Sell a ₹5,200 Call Option for ₹100.
  • Total Credit Received: ₹100 + ₹100 = ₹200.

Calculations:

• Maximum Profit: Total credit received = ₹200.
• Maximum Loss: Undefined (since it depends on how far the stock price moves beyond the break-even points).
• Break-even Points:
  • Lower Break-even = Lower strike price – Total credit = ₹4,800 – ₹200 = ₹4,600.
  • Upper Break-even = Upper strike price + Total credit = ₹5,200 + ₹200 = ₹5,400.

Summary

• Total Credit Received: ₹200.
• Max Profit: ₹200.
• Max Loss: Undefined.
• Break-even Points: ₹4,600 and ₹5,400

Impact of Time Decay on Short Strangle

Time decay is your buddy here. Every day, the options lose value, helping you profit as long as the stock doesn’t make any wild moves.

Impact of Implied Volatility on Short Strangle

Short strangles love decreasing volatility. Lower volatility means lower option prices, making it cheaper to buy back the options and close the trade.

Adjusting a Short Strangle

If the stock starts to move too much, you can adjust by rolling the options or adding positions to reduce risk.

Short Strangle Adjustment example:

• Stock drops: Close the call option and sell a new call closer to the stock price.
• Stock rises: Close the put option and sell a new put closer to the stock price.

Hedging a Short Strangle

If the stock moves a lot, buy a long option to cap your risk.

Example:

• Stock dropping: Buy a ₹4500 put.
• Stock rising: Buy a ₹5500 call.

This limits your maximum loss but reduces your maximum profit.

Bottom Line

In summary, a short strangle is like betting your lazy cousin won’t leave the couch. You get paid if nothing much happens, but if there’s sudden excitement, you’re in for a rough ride. Use it when you think the market will be calm, but always have a backup plan!