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A short strangle is a bearish bet on volatility. Like its sister trade, the short straddle, it’s a limited profit/unlimited risk strategy played exclusively to collect premium.
How is it set up?
The short strangle consists of two legs, one short out-of-the-money call and one short out-of-the-money put. It’s generally employed over a short duration to limit the chances of a strong move in the underlying. And it’s nearly always closed or rolled out if the underlying reaches either of the two strikes.
The question of whether to sell a straddle or a strangle is not an easy one, and it’s based on two considerations:
- How much premium is on offer from each approach; and
- The likelihood that volatility will be negligible before the options expire.
Straddles, of course, offer the greater initial credit. But strangles offer more security, as the strikes are situated further from the price of the underlying.
Let’s have a look at a case study to better understand the relative advantages of the short strangle strategy.
This is chart of Toronto Dominion Bank (NYSE: TD) for a period of nearly 10 months:
By late August, the stock has made an incredible move higher, though average daily volumes have fallen sharply (in yellow). Sensing the move is at an end, and the stock is likely to take a breather, you consider a trade. With no significant news on the horizon, but plenty of implied volatility still embedded in the options, you decide to either sell a straddle or a strangle.
The numbers look as follows.
The shares are sitting at $31 (red circle), and the November 31 straddle, situated roughly 10 weeks out, sells for $5 ($2.50 for the 31 call and $2.50 for the 31 put). Against that, the strangle, composed of a 33 call and a 29 put, is fetching $3.50 (black squares).
Your lust for money is a strong as the next fella, but you’ve got a nagging doubt about the stock. You worry it could still trip the light fantastic, start trending strongly and end up costing you a lot of money.
After some sober consideration, you decide to put less cash in your pocket and sell the strangle. Better to sleep at night, you figure, than pop sedatives for the next 2 ½ months before expiry.
And you’re right!
Your timing is excellent. For the next three months the shares trade in a tight range and settle at $32 on expiry. Both options close out of the money, and you keep 100% of your initial premium, a $350 profit.
The trade, of course, was never in danger, as the stock held closely to its price when you set it. You also had the cushion of your premium in case the stock started moving erratically. The trade was safe anywhere between the upper and lower break-even points of $36.50 and $25.50 (call strike + premium & put strike – less premium).
Note: Had you sold the straddle, your profit would have been $400 (initial premium – [price at expiry – strike price] x 100), or ($5 – [$32 – $31] x 100). That would have been superior to the straddle, but with less protection, as the break-evens for the straddle arrived at $36 and $26.
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