The short strangle is a two-legged option spread meant to capitalize on a period of stagnant price action for the underlying stock. The strategy involves the sale of two out-of-the-money options -- one call and one put -- and the ultimate goal is for both to expire worthless, allowing the trader to retain the upfront credit received as the maximum potential profit.
However, this tactic is best reserved for experienced speculators. Thanks to the combination of a short put and a short call, this strategy requires a margin account ... and it also sports a fairly daunting risk profile. Here's a closer look at a short strangle in action.
With Stock XYZ stuck in a tight trading range near the $56 level, you simultaneously sell to open one 57.50-strike call and sell to open one 55-strike put. The call is bid at 0.21, while the put is bid at 0.39, resulting in a net credit of 0.60 (0.21 + 0.39). Accounting for 100 shares per contract, you've collected $60 at the outset of the trade.
Now, you sit back and wait until expiration, hoping XYZ doesn't experience any major moves that would push one of your options into the money.
The $60 you netted from selling both options is your maximum potential profit on a short strangle. If the stock settles anywhere between the two sold strikes prior to expiration, this entire amount is yours to keep. Meanwhile, both options can be left to expire worthless, so no further action must be taken to exit the position.
There are two breakeven points on the short strangle, which are calculated by adding the net credit to the call strike and subtracting the net credit from the put strike. In this example, your profit zone ranges from $58.10 on the upside (57.50 + 0.60) to $54.40 on the downside (55 - 0.60).
If one of your options finishes in the money at expiration, however, you must buy to close the contract, resulting in an additional transaction fee.
While your profit on a short strangle is strictly limited, your risk is quite high. If one of the aforementioned breakeven rails is breached, losses will begin to add up quickly. Should XYZ plummet to zero, the maximum potential loss is equal to the put strike less net credit, or 54.40. Multiplied by 100 shares per contract, that's a downside risk of $5,440.
On the other hand, there's no limit to how much money you can lose in the event of a rally, as there's no cap to how high a stock can rise. Should the shares unexpectedly advance, your losses will begin to add up with each step north of breakeven at $58.10.
Since you've sold two options to initiate the short strangle, you'd ideally like to see implied volatility decline. All other factors being equal, a downturn in implied volatility will reduce the value of your options -- thereby making it cheaper to buy them back, should the need arise.
Whenever you're dealing with "naked" short options, as in a short strangle, you'll be required to deposit a predetermined amount of investing capital into a margin account to cover potential losses. Ideally, the trade will play out as expected, and you won't have to forfeit these funds -- but it's worth noting that this capital will be tied up throughout the duration of the trade, and therefore unavailable to you for other investing purposes.
Since the success of a short strangle depends upon very little movement in the underlying stock, it makes sense to narrow your focus to shorter-term options. This gives the shares less time to move against you. Plus, be sure to check the company's corporate calendar to ensure there are no upcoming events that could provide a potential catalyst for the stock to move drastically higher or lower.