Short Strangle

The Short Strangle Setup

Suppose XYZ Corp is trading at $50 per share. Anticipating little price movement in the stock, you sell a $55 strike call for $2 and a $45 strike put for $2. Both options expire in three months, netting you a total premium received of $4.

Who Should Consider It

This strategy is most appropriate for seasoned traders who feel that the stock price will experience low volatility and remain within a defined range. It’s very effective in neutral market conditions with high option premiums.

Strategy Explained

By selling both a call and a put, you collect premiums upfront, which represents your maximum potential profit. The goal is for both options to expire worthless, allowing you to keep the entire premium.

Breakeven Process

This strategy has two breakeven points:

• Upper breakeven: Call strike price + total premiums received.
• Lower breakeven: Put strike price - total premiums received.

For XYZ Corp, breakeven points are:

• Upper breakeven: $55 + $4 = $59
• Lower breakeven: $45 - $4 = $41

The sweet spot for this strategy is when the stock price stays between the two strike prices through the expiration date, maximizing the decay of both options’ premiums

Max Profit Potential

The maximum profit is limited to the premiums received from selling the call and put options, which in this example is $4.

Max Loss

The upside is theoretically unlimited in loss, as the stock price can rise significantly above the call strike, and the loss is substantial on the downside, as the stock can drop well below the put strike, and the stock could fall to zero.

Risk

The risk is significantly high due to the unlimited potential loss on the upside. The stock price moving outside of the range of strike prices poses the greatest risk, necessitating careful position management and possibly preventive action to mitigate losses.

Time Decay

Time decay (theta) works in favor of this strategy. When the clock is ticking, if the stock price moves into either of the strike prices, then at expiration, the value of the two options will cause them to expire worthlessly, thus making maximum profit.

Implied Volatility

The lower the implied volatility after entering the trade, the more beneficial this strategy proves. This is a desirable aspect as it minimizes the likelihood of substantial stock price movements that may push the options into the money. Reduced volatility often translates to lower values sold out by the call writer.

Conclusion

A Short Strangle is a good trade when you feel a stock is going to be fairly static, and you have managed the risk effectively. This gives high potential income from premiums received but huge risks if the market acts irrationally. A clear exit strategy and good risk management will ensure traders don’t lose unlimited amounts.