The short strap strangle is a mirror image of the strap strangle, with all the options being sold rather than bought.
How does that look in practice?
Well, the trader sells two out of the money calls and one out of the money put.
And why does he do it?
The short strap strangle is a neutral strategy that’s employed when a trader expects minimal volatility before options expiry. Yet while the expectation is for little movement, the trader’s bias is also mildly bearish; should the stock break in any direction, he believes it will likely be lower.
That creates an asymmetric risk profile for an already theoretically unlimited risk trade. Should the stock trend strongly in either direction, the losses will be significant, though twice as painful should the move be to the downside.
Greater Benefits Than Traditional Short Strangle
On the other hand, short strap strangles will generate more premium than simple short strangles for the simple fact that one additional option is sold. That extra premium also serves to push wider the break-even levels for the trade, making it somewhat safer in that regard than a traditional short strangle.
Let’s look now at a case study that will illustrate all the essentials of the trade, including the importance of calculating accurate break-even levels.
Below is a chart of Discover Financial Services (NYSE: DFS) for close to half a year.
Shares of Discover Financial have been caught in a long, sideways grind, and you expect it to continue for a couple of months more, at least. At the same time, you’re aware of some senior management issues in the company that might be made public shortly and have the potential to generate bad feelings on the part of investors.
It’s a tough call, but your best instincts tell you that there’s money to be had by selling options on the stock for the short term, before any bad news has time to bite and potentially pull the stock into the gutter.
Strangling Cash Out of DFS
After a chat with your broker, you decide to sell a short strap strangle and cull some premium from the lack of volatility. In early May (red circle), with the stock changing hands at $59, you sell two July 61 calls for $2 each and one July 57 put for $2. Your total credit on the trade is $6.
And it turns out you’re right. For the next two months the stock does next to nothing, meandering in a range between roughly $57 and $60.
And then, just two days before expiry, the Times runs an exposé on the same senior management story you feared would leak. The stock is on its way to losing 10% in a jiff, when options expiry steps in to save you.
The Final Tally
The shares expire at $55.50, the calls expire worthless, but the single put is in the money $1.50. You buy it back before the close and that’s where it ends. A net profit of $450 ([$6 – $1.50] x 100) is all yours.
Short strap strangles are unlimited risk/known reward trades, with the greatest danger occurring should the underlying start trending strongly higher. Losses are potentially unlimited and begin accruing beyond the break-even points for the trade.
Upside break-even is calculated like this: call strike plus initial premium collected/2. In the above example, that would be at (61 + [6/2]), or 64.
Downside break-even resides at the put strike less initial premium collected. In our example, it would be (57 – 6), or 51.
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