Short strangle

  • The Options Institute at CBOE®

Goal

To profit from little or no price movement in the underlying stock.

Explanation

Example of short strangle

Sell 1 XYZ 105 Call at 1.50
Sell 1 XYZ 95 Put at 1.30
Net Credit   = 2.80

A short strangle consists of one short call with a higher strike price and one short put with a lower strike. Both options have the same underlying stock and the same expiration date, but they have different strike prices. A short strangle is established for a net credit (or net receipt) and profits if the underlying stock trades in a narrow range between the break-even points. Profit potential is limited to the total premiums received less commissions. Potential loss is unlimited if the stock price rises and substantial if the stock price falls.

Maximum profit

Profit potential is limited to the total premiums received less commissions. The maximum profit is earned if the short strangle is held to expiration, the stock price closes at or between the strike prices and both options expire worthless.

Maximum risk

Potential loss is unlimited on the upside, because the stock price can rise indefinitely. On the downside, potential loss is substantial, because the stock price can fall to zero.

Breakeven stock price at expiration

There are two potential break-even points:

  1. Higher strike price plus total premium:
    In this example: 105.00 + 2.80 = 107.80
  2. Lower strike price minus total premium:
    In this example: 95.00 – 2.80 = 92.20

Profit/Loss diagram and table: short strangle

Short 1 105 Call at 1.50
Short 1 95 Put at 1.30
Total Credit   = 2.80
Stock Price at Expiration Short 105 Call Profit/(Loss) at Expiration Short 95 Put Profit/(Loss) at Expiration Short Strangle Profit / (Loss) at Expiration
110 (3.50) +1.30 (2.20)
109 (2.50) +1.30 (1.20)
108 (1.50) +1.30 (0.20)
107 (0.50) +1.30 +0.80
106 +0.50 +1.30 +1.80
105 +1.50 +1.30 +2.80
104 +1.50 +1.30 +2.80
103 +1.50 +1.30 +2.80
102 +1.50 +1.30 +2.80
101 +1.50 +1.30 +2.80
100 +1.50 +1.30 +2.80
99 +1.50 +1.30 +2.80
98 +1.50 +1.30 +2.80
97 +1.50 +1.30 +2.80
96 +1.50 +1.30 +2.80
95 +1.50 +1.30 +2.80
94 +1.50 +0.30 +1.80
93 +1.50 (0.70) +0.80
92 +1.50 (1.70) (0.20)
91 +1.50 (2.70) (1.20)
90 +1.50 (3.70) (2.20)

Appropriate market forecast

A short strangle profits when the price of the underlying stock trades in a narrow range between the breakeven points. The ideal forecast, therefore, is “neutral or sideways.” In the language of options, this is known as “low volatility.”

Strategy discussion

A short – or sold – strangle is the strategy of choice when the forecast is for neutral, or range-bound, price action. Strangles are often sold between earnings reports and other publicized announcements that have the potential to cause sharp stock price fluctuations.

It is important to remember that the prices of calls and puts – and therefore the prices of strangles – contain the consensus opinion of options market participants as to how much the stock price will move prior to expiration. This means that sellers of strangles believe that the market consensus is “too high” and that the stock price will stay between the breakeven points.

“Selling a strangle” is intuitively appealing to some traders, because “you collect two option premiums, and the stock has to move ‘a lot’ before you lose money.” The reality is that the market is often “efficient,” which means that prices of strangles frequently are an accurate gauge of how much a stock price is likely to move prior to expiration. This means that selling a strangle, like all trading decisions, is subjective and requires good timing for both the sell (to open) decision and the buy (to close) decision.

Impact of stock price change

When the stock price is between the strike prices of the strangle, the negative delta of the short call and positive delta of the short put very nearly offset each other. Thus, for small changes in stock price between the strikes, the price of a strangle does not change very much. This means that a strangle has a “near-zero delta.” Delta estimates how much an option price will change as the stock price changes.

However, if the stock price “rises fast enough” or “falls fast enough,” then the strangle rises in price, and a short strangle loses money. This happens because, as the stock price rises, the short call rises in price more and loses more than the put makes by falling in price. Also, as the stock price falls, the short put rises in price more and loses more than the short call makes by falling in price. In the language of options, this is known as “negative gamma.” Gamma estimates how much the delta of a position changes as the stock price changes. Negative gamma means that the delta of a position changes in the opposite direction as the change in price of the underlying stock. As the stock price rises, the net delta of a short strangle becomes more and more negative, because the delta of the short call becomes more and more negative and the delta of the short put goes to zero. Similarly, as the stock price falls, the net delta of a short strangle becomes more and more positive, because the delta of the short put becomes more and more positive and the delta of the short call goes to zero.

Impact of change in volatility

Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices – and strangle prices – tend to rise if other factors such as stock price and time to expiration remain constant. Therefore, when volatility increases, short strangles increase in price and lose money. When volatility falls, short strangles decrease in price and make money. In the language of options, this is known as “negative vega.” Vega estimates how much an option price changes as the level of volatility changes and other factors are unchanged, and negative vega means that a position loses when volatility rises and profits when volatility falls.

Impact of time

The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion, or time decay. Since short strangles consist of two short options, the sensitivity to time erosion is higher than for single-option positions. Short strangles tend to make money rapidly as time passes and the stock price does not change.

Risk of early assignment

Stock options in the United States can be exercised on any business day, and the holder of a short stock option position has no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options.

Both the short call and the short put in a short strangle have early assignment risk. Early assignment of stock options is generally related to dividends.

Short calls that are assigned early are generally assigned on the day before the ex-dividend date. In-the-money calls whose time value is less than the dividend have a high likelihood of being assigned. Therefore, if the stock price is above the strike price of the call in a short strangle, an assessment must be made if early assignment is likely. If assignment is deemed likely, and if a short stock position is not wanted, then appropriate action must be taken before assignment occurs (either buying the short call and keeping the short put open, or closing the entire strangle).

Short puts that are assigned early are generally assigned on the ex-dividend date. In-the-money puts whose time value is less than the dividend have a high likelihood of being assigned. Therefore, if the stock price is below the strike price of the put in a short strangle, an assessment must be made if early assignment is likely. If assignment is deemed likely and if a long stock position is not wanted, then appropriate action must be taken before assignment occurs (either buying the short put and keeping the short call open, or closing the entire strangle).

If early assignment of a stock option does occur, then stock is purchased (short put) or sold (short call). If no offsetting stock position exists, then a stock position is created. If the stock position is not wanted, it can be closed in the marketplace by taking appropriate action (selling or buying). Note, however, that the date of the closing stock transaction will be one day later than the date of the opening stock transaction (from assignment). This one-day difference will result in additional fees, including interest charges and commissions. Assignment of a short option might also trigger a margin call if there is not sufficient account equity to support the stock position.

Potential position created at expiration

There are three possible outcomes at expiration. The stock price can be at a strike price or between the strike prices of a short strangle, above the strike price of the call (the higher strike) or below the strike price of the put (the lower strike).

If the stock price is at a strike price or between the strike prices at expiration, then both the call and the put expire worthless and no stock position is created.

If the stock price is above the strike price of the call (the higher strike) at expiration, the put expires worthless, the short call is assigned, stock is sold at the strike price and a short stock position is created. If a short stock position is not wanted, the short call must be closed (purchased) prior to expiration.

If the stock price is below the strike price of the put (lower strike) at expiration, the call expires worthless, the short put is assigned, stock is purchased at the strike price and a long stock position is created. If a long stock position is not wanted, the put must be closed (purchased) prior to expiration.

Note: options are automatically exercised at expiration if they are one cent ($0.01) in the money. Therefore, if the stock price is “close” to one of the strike prices of a short strangle as expiration approaches, and if the holder of a short strangle wants to avoid having a stock position, the short option in danger of be assigned must be closed (purchased) prior to expiration.

Other considerations

Short strangles are often compared to short straddles, and traders frequently debate which the “better” strategy is.

Long strangles involve buying a call with a higher strike price and buying a put with a lower strike price. For example, buy a 105 Call and buy a 95 Put. Long straddles, however, involve buying a call and put with the same strike price. For example, buy a 100 Call and buy a 100 Put.

Neither strategy is “better” in an absolute sense. There are tradeoffs.

There are three advantages and one disadvantage to a short strangle. The first advantage is that the breakeven points for a short strangle are further apart than for a comparable straddle. Second, there is a greater chance of making 100% of the premium received if a short strangle is held to expiration. Third, strangles are more sensitive to time decay than short straddles. Thus, when there is little or no stock price movement, a short strangle will experience a greater percentage profit over a given time period than a comparable short straddle. The disadvantage is that the premium received and maximum profit potential for selling one strangle are lower than for one straddle.

A short straddle has one advantage and three disadvantages. The advantage of a short straddle is that the premium received and the maximum profit potential of one straddle (one call and one put) is greater than for one strangle. The first disadvantage is that the breakeven points are closer together for a straddle than for a comparable strangle. Second, there is a smaller chance that a straddle will make its maximum profit potential if it is held to expiration. Third, straddles are less sensitive to time decay than strangles. Thus, when there is little or no stock price movement, a short straddle will experience a lower percentage profit over a given time period than a comparable short strangle.