While only directional trades are possible with financial instruments such as futures, stocks, or ETFs - i.e., speculating on rising or falling prices - financial instruments such as futures, stocks, or ETFs offer Options sometimes the possibility of Sideways movements of a market. One of the most popular Option strategies for this application is the Short Strangle. In this article you will learn what a short strangle is and what to look for when trading strangles.
Definition Short Strangle
A Short Strangle consists of a sold Out Of The Money call option (Short Call) and a sold Out Of The Money put option (Short Put) with the same maturity. With a short strangle, traders speculate that the underlying on the expiration date will between the two strikes of the options sold.
P&L diagram of a short strangle
By selling a call option and a put option at the same time, two times a Premium income is achieved. This represents the maximum possible profit, as can be seen in the P&L diagram with the horizontal line.
If the price of the underlying rises above the strike price of the short call or falls below the strike price of the short put, the profit is reduced or a loss is incurred if the underlying rises above/falls below the break-even point.
What should I pay attention to when trading a short strangle?
In the following section, we go into more detail about the individual parameters of a short strangle and explain how it reacts to changes in time and implied volatility.
Maximum loss
The maximum possible loss of a short strangle is not calculable or theoretically unlimited high, since the underlying could fall to zero or rise infinitely. For this reason, it is important to close the trade early if a loss is imminent in order to limit the loss.
Maximum profit
The maximum profit occurs if the price of the underlying is below the strike price of the short call and above the strike price of the short put on the expiration date. In this case, both the short call and the short put expire worthless. The maximum profit corresponds to the Amount of the option premium collected at the beginning (Credit), less the financing costs of the trade.
Break Even Point
The two break even points of a short string can be calculated by adding the premium (credit) to the strike price of the short call or subtracting it from the strike price of the short put.
Break Even Point (1) = Strike Price Short Call + Credit
Break Even Point (2) = Strike Price Short Put - Credit
Market assessment
Since the short strangle generates a profit when the underlying trades within a certain trading range, it is mostly used to react to a Sideways movement or to speculate on a consolidation. With a slightly bullish or slightly bearish market opinion, the short strangle can also be used. If necessary, the base prices can be selected so that the underlying has a little more "leeway" in one direction or the other.
Implied volatility
The short strangle benefits during the term of the options from a declining implied volatility (IV). When volatility rises, on the other hand, option prices rise, which has a negative effect on the short strangle. For this reason, option traders often use short strangles after a rise in the IV, thus speculating on a declining volatility.
Residual term and fair value expiry
The time value decay of options basically has a positive effect on sold options and a negative effect on bought options. Since the short strangle consists of two sold options, benefits this (twice) from the Time value loss of the options.