Utilizing a short strangle means you aren't relegated to the sidelines when the stock market isn't trending, or a stock you are interested in isn't moving. Sideways markets present opportunities for astute traders, especially when incorporating options. Option strategies allow traders to potentially profit from all sorts of trading conditions, including sideways markets, if their prediction ends up being right. Here's how to use the short strangle options strategy to profit from a sideways market.
Why Sideways Markets Are Risky
Trending trading is where many traders place their focus because the trend provides a directional bias and profitable edge. As long as the trend persists the trader makes money. Trends can reverse though, or may come to a halt for extended periods of time as the price moves sideways, moving within a band of support and resistance.
These sideways times typically cause traders to wonder about the trend. They enter and exit positions but the stock doesn’t really move. In other words, for most traders a sideways market is a scary place full of uncertainty and risk depending on which way the price eventually price breaks out, and when that will occur.
For a trader with options strategy knowledge, a sideways market can present an opportunity.
Be sure to also read What are Stock Options.
What's a Short Strangle?
A short strangle options strategy is the simultaneous selling of both a put and a call option. Both options are sold out of the money, preferably a decent distance away from the current underlying stock price. For example, if a stock is stuck near $40 and barely moving, a put option is sold at $38, for example, and a call option sold at $42.
The options seller receives premiums for both the call and put. If the price stays between $38 and $42 (called strike prices), in this example, then both options expire worthless and the short strangle seller gets to keep the premium received.
The short strangle is designed to make money during a sideways market. If the market breaks out though, and moves above $42 or below $38, then the short strangle faces potentially large losses depending on how far the price runs.
While losses can get large when holding a short strangle position, an option seller can close out their position at any time to reduce damage. Just like a stop loss can be placed on a stock position, if the price breaks above or below $42 or $38 respectively the seller has the ability to close out the option positions, giving up the premiums, and taking a small loss.
Who Should Use the Short Strangle
It makes sense to use a short strangle during times of low volatility, or potential low volatility. If you believe a stock or other asset is going to move sideways at least until the options sold (a put and a call) expire, then utilizing this strategy makes sense. It’s a way to profit even when the profit potential is very small or non-existent in the underlying stock.
Short-term traders can utilize the strategy as well as longer-term traders. The longer the time till expiry the greater the premium received, but that also leaves more time for the trade to go sour. The shorter the time till expiry typically the smaller the premium but there is less time for the trade to sour. There obviously is a trade off here.
Due to the high risk if the underlying stock moves beyond either of the strike prices, this strategy is recommended for advanced options traders, or at minimum someone who is very disciplined and capable of cutting the loss on losing trades very quickly.
Risks and Rewards
To understand the risks, profit potential and how to execute a short strangle, here’s a real example using Istar Financial (STAR) as the underlying stock, and using end of day quotes for the options from the Chicago Board Options Exchange (CBOE.com).
On August 18, 2014 the price of STAR closed at $15.01. The high of the current range is $15.19, therefore a call could be sold at $16 (above the high of the range). The low of the range is $13.79, therefore a put could be sold at $13.00 (below the low of the range). Both the call and the put are outside the current price. As long as the price stays between $16 and $13 the trade will be profitable.
October $16 calls sold for $0.50, while $13 puts are selling for $0.25
The premiums represent the premium received for each share sold. Assume the trader sells 500 shares worth of options on each the put and call.
The amount received equals: 500 x $0.50 = $250 for the calls, and 500 x $0.25 = $125 for the puts for a total of $375 (less commissions).
If at the October expiry the price is between $16 and $13 the option short strangle seller gets to keep the $375.
If at the October expiry the price is above $16, or below $13 they face an approximate $500 loss for each dollar the price moves beyond these thresholds.
For example, if the price is at $18 when the options expire, the trader faces a loss of $2 per share on the call option. Holding 500 shares worth of call options, the seller is required to make good on this transaction, which requires dishing up $1000. The trader received $375 initially so the loss on the trade is $1000 – $375 = $625.
If the price is at $12 when the option expires the faces a loss of $1 per share on the put option. Holding 500 shares worth of put options, the trader faces a loss of $500. $375 was received initially so the actual loss is ($500) + $375 = ($125). Figures may vary slightly based on the actual market value of options just prior to expiry.
Remember though, as an option seller you can close out the position at any time. If the price is breaking out of the range, it is possible to cut losses before expiry, and possibly even pocket a small portion of the premium before it is completely lost or the loss becomes larger.
The Bottom Line
The short strangle options strategy is used in sideways markets, and involves selling an out of the money call and put. The option seller receives the premium for the option sales, and if the price is between the two strike prices at expiry the traders keeps the premium. The risk comes in when the price moves above or below the call or put strike price respectively. This can result in large losses, therefore the strategy works in sideways markets, but doesn’t fair well in trending markets. The short strangle seller can exit at any time before expiry to lock in part of the premium, or cut their losses.
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