Short Strangle: The Ultimate Guide

Short Strangle: The Ultimate Guide

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short strangle option strategy

This is the ultimate guide to trading the short strangle option strategy in 2019.

And let me be clear about something:

This is NOT a lame “buy this option, sell this option surface level” type of post.

Instead, you’re going to see detailed examples of how the short strangle works right now… and will even work in 2019.

So, if you’re looking to up your short strangle game this year, you’ll love this guide.

Let’s dive right in.

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1

Short Strangle Basics

Before we get too deep into the details, let’s first establish what the short strangle options trading strategy is and how you can add it to your trading toolbox.


In fact, without this strategy is like having a toolbox without a simple screwdriver.

 

The question is:


What is a strangle, exactly? And how can you use it to make money?

The Short Strangle Setup: a Dead-Simple Explanation

A short strangle option strategy is the combination of these options:

  • Sell 1 out of the money put
  • Sell 1 out of the money call

Components of a short strangle

Sell one out of the money put option and sell one out of the money call option with 30-45 days until expiration.

That might sound complicated, but it isn’t.

If you’re familiar with an iron condor, you’ll even see some similarities.

This options trading strategy simply is selling two naked out of the money options on either side of the current stock price…

... hoping that the stock price stays between the two short strikes, time passes, and volatility contracts.

And without any risk definition.

So, with a neutral trading strategy like a short strangle, you simple want time to pass, volatility to contract, and the stock price to stay in between your two short strikes.

Let’s go through a theoretical example of the strangle strategy.

Let’s say the current stock price is $100, so you sell a $80 strike put option and a $120 strike call option.

Since you’re selling two options, you initiate this trade for a net credit, so you are collecting option premium upfront.

short strangle profit diagram

Let’s say you can establish this all for a credit of $1.00 (in options terms), $100 in dollar terms.

Now, let’s go through some key characteristics of the short strangle option strategy.

Short Strangle Maximum Profit Potential

Calculating the maximum profit potential on a short strangle is super simple.

All you have to do is look at the initial credit receive when you initiated the trade.

So, in our example, the maximum profit potential would be $1.00, which is $100 in dollar terms.

This is the most you can possibly make on this trade, since the short strangle is a defined profitability type of strategy.

Short Strangle Maximum Loss Potential

This is where many new options traders tend to become hesitant on using this particular options trading strategy…

That’s because theoretically unlimited risk when you sell two naked option.

Here’s what I mean.

If you sell a naked put, the stock price could theoretically go all the way to zero (though very unlikely).

This means that you could be forced to buy shares of stock (since you’re selling the put option) at a predetermined price, when the stock is not worth anything in the open market.

On the other side, the stock price could rise infinitely.

In this case, you could be forced to short shares of stock (since you’re selling the call option) at a predetermined price, when the stock is worth infinitely more in the open market than where you shorted it.

So, yes theoretically there’s unlimited potential loss when you short a strangle.

But in practice, you can place a number to your maximum risk.

Short Strangle Margin As An Approximation For Maximum Risk

This part is going to get pretty math heavy, so buckle up.

In practice, you can define a range the stock price is likely to land given parameters like time and volatility.

Then, you can come up with a probability distribution to tell you the exact probability that a stock price will land at a certain price by a certain date.

options trading normal distribution

In fact, when you short a strangle, your brokerage firm will hold capital from your account in the form of margin (in case you incur losses).

The brokerage firm typically calculates margin for a short strangle at a two standard deviation move.

Margin and Buying Power

Margin, sometimes referred to as buying power is the amount of money the brokerage firm decides to hold from your account in case of losses.

So, the brokerage firm looks at what your loss would be if the stock price were to move two standard deviations lower or higher.

The brokerage firm feels comfortable defining the risk at two standard deviations because that covers 95% of all occurrences.

If all that math and statistics, just went over your head, just look at the margin requirement that your broker calculates to determine your maximum loss on the short strangle.

How To Calculate A Short Strangle’s Break Even Price

A short strangle option strategy has two break even prices because you could potentially lose to the downside on the naked short put or the upside on the naked short call.

Let’s go through the break even price calculations:

  • To calculate your downside break even price, take your short put strike and subtract the initial credit collection
  • To calculate your upside break even price, take your short call strike and add the initial credit collection.

So, if we continue along with our short $80/$120 short strangle for $1.00 in credit, your downside break even price is $79 and the upside break even price is $121.

As long as the stock price stays between $79 and $121, you’ll turn a price from the short strangle.

However, if the stock price ends up moving outside that zone, then you’ll gave losses on your hands.

How To Calculate A Short Strangle’s Probability Of Profit

Let’s now go through a quick and easy way to estimate your probability of success when you short a strangle.

Take 100 minus the delta of the call option plus the delta of the put option.

So, let’s say you sell a 16 delta call option and a 16 delta put option.

So in this example, 16 plus 16 is 32, so 100 minus 32 is 68.

This means that your probability of profit is about 68%.

Most brokerage firms automatically calculate this number for you, so you don’t have to do the math yourself.

Short strangle trade detail

Whenever I trade a short strangle, I target at least a probability of profit of around 68%, since that covers a one standard deviation move in the underlying stock price.

How Does Time Decay Affect Short Strangles?

A short strangle is a theta positive options trading strategy. 

This means that as each day passes, the value of the options that you sold decrease.

Decreasing options values is good for options sellers because this means that you can buy back the options at a lower price than you sold them for, profiting off the difference.

This is why the short strangle is one of our favorite options trading strategies.

All you have to do is set up the trade and wait to have a winner on the table.

(If everything goes according to plan)

As long as the stock price doesn’t make any crazy moves, you’ll profit due to the simple passage of time.

How Does Volatility Affect Short Strangles?

Using a short strangle in the right volatility environment could make or break your overall profitability. 

That’s because short strangles are very sensitive to changes in implied volatility.

This means you should only use this strategy in high implied volatility environments.

High implied volatility means expensive option prices, so you can sell the strangle for the highest price possible.

This also means that after you’ve initiated a short strangle position, you want implied volatility to collapse.

When implied volatility falls, options prices also fall.

So, if the price of the options that you had sold fell, then you will be able to buy back the options for a cheaper price, allowing you to profit off the difference.

This is a piece of options trading that many newer traders tend to miss since it’s hard to conceptualize volatility.

2

Real Life Short Strangle Example

Now that we got all the theoretical stuff out of the way, let’s take a look at a real life strangle example.


And yes: this example is straight out of my tastyworks trading platform.


The question is:


How does the short strangle option strategy actually work in real life?


Well, that’s what this chapter is all about.

Short Strangle Example

I’ve constructed a short strangle in my tastyworks trading platform to illustrate all the concepts we’ve gone through so far.

Here’s a screenshot of the strangle setup:

short strangle setup

The strikes I picked are:

  • Sell 1 130 strike put option
  • Sell 1 160 strike call option

The market for the short strangle spread is currently trading for $2.50, which is equal to $250 in dollar terms.

Here’s what this particular spread looks like on a profit and loss diagram.

short strangle profit and loss diagram

So, the maximum potential profit on this particular short strangle is $250.

The broker is also requiring about $1,500 in buying power reduction, which we can estimate is the maximum potential loss in a worst case scenario.

short strangle buying power reduction

So, with the maximum profit and loss estimate, this looks like a 16% return on capital.

Not too shabby.

The break even prices for this short strangle is $127.50 to the downside and $162.50 to the upside.

So, at expiration, if the stock price lands in between those two prices, this option spread will make a profit.

If instead the stock price lands outside those two points, there will be a loss.

It’s also important to note that there’s a delta of 2, which is basically neutral. This means that you don’t want the stock price to move much.

Also, this particular strangle has a theta value of positive 10, so all else being equal, this trade will profit $10 every day that passes.

Lastly, the tastyworks trading platform calculated a 73% probability of profit.

So, this trade has a very high chance of making some level of profit through the life of the trade.

3

What's The Difference Between a Strangle and a Straddle?

Many new options traders often confuse the strangle and the straddle.

 

Mostly because these are two very similar strategies, with one slight nuance.

 

So, let’s figure out what the difference is in this chapter.

Strangles vs Straddles

Strangles and straddles are both undefined risk options spreads that benefit from non-movement in the price of the underlying stock. 

Both strategies are comprised of one short put and one short call.

The difference between the two is that the strangle has its strikes situated out of the money at difference strikes, while the straddle has its strikes situated at the money at the same strike.

Here’s what the straddle looks like on a profit and loss diagram:

short straddle profit and loss diagram

With the straddle, you are selling two at the money options (red tiles stacked), so you are collecting a much larger credit.

The trade off is that there is a smaller range for the stock price to move around to remain profitable.

Both the strangle and the straddle are net selling premium and are undefined risk strategies.

When To Use Strangle vs Straddle

So, the only real difference between the strangle and the straddle is the strike placement.

What situations works the best for the strangle or the straddle?

Both the strangle and the straddle are best used in high implied volatility environments.

But the straddle is best used in very high implied volatility environments.

This is because very high implied volatility warrants a more aggressive options strategy.

If, on the other hand, implied volatility is elevated, but not the highest it’s been, a strangle is a better choice because the short strangle has a higher probability of success.

Another factor to consider when you are choosing strangle vs straddle is how strong your conviction is for the stock price staying where it is.

Since, the straddle has a much smaller range of profitability, you should have a strong conviction that the stock price will stay in a smaller range.

4

What's The Difference Between a Strangle and an Iron Condor?

The short strangle and the iron condor are two very similar strategies.


In fact, “the guts” of the trades are almost identical.

 

The difference?


One is defined risk and one is undefined risk.

 

Let’s get into the details.

Strangle Vs Iron Condor

So, both the strangle and the iron condor are short premium strategies that sell out of the money options.

The difference is that the strangle is an undefined risk strategy, while the iron condor is a defined risk strategy.

short strangle profit and loss diagram

Strangle Profit and Loss Diagram

iron condor profit and loss diagram

Iron Condor Profit and Loss Diagram

There are several things that defining risk does:

  • Defining risk limits your potential losses
  • Defining risk lowers your probability of profit
  • Defining risk lowers your maximum profit potential
  • Defining risk decreases your profitability range
  • Defining risk reduces your profit and loss volatility
  • Defining risk reduces your theta and vega exposure

So, in summary the iron condor is a “safer” version of the short strangle option strategy.

But the trade off for making it a “safer” trade is a lower probability of success and a lower profit potential.

What Situation Is Best For The Short Strangle vs Iron Condor?

So, now that we know what the difference between the short strangle and the iron condor is, why would you pick one over the other?

The answer depends mainly on your risk tolerance.

If you either have a larger risk tolerance and are willing to risk a little more for a higher probability of success and profit potential, then the short strangle is your best bet.

Also, if you have a larger account size or a margin account, a strangle will work the best.

If, on the other hand, you are less risk tolerance or you have a smaller account size or an IRA account that doesn’t have margin benefits, an iron condor is the best choice.

This is because the iron condor is defined risk, so one trade loss won’t put you out of business.

It is also very difficult to sell naked options in an IRA account or a cash account because there is no margin relief. If you do happen to sell naked options in an IRA account, then you’ll be margined for the full amount of 100 shares of stock for every one options contract that you sell.

This could mean tying up a large amount of capital for one trade, reducing your overall return on capital.

Now It's Your Turn

So, that’s it for my guide to the short strangle option strategy in 2019.


Now I want to turn it over to you: Is the short strangle an options strategy that you are going to implement in your options trading portfolio?


Or are you going to use an alternative strategy like the iron condor instead?


Either way, let me know by leaving a quick comment below right now.

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