Getting Started With Options

Using Short Strangles to Realize Profit on Range-Bound Stocks
Andrea Kramer (akramer@sir-inc.com)

Straddles and strangles are options strategies for traders who expect big moves out of a stock. The short versions of these stragegies -- for options sellers, rather than buyers -- reward traders when a stock doesn't move at all. This article examines the short strangle strategy.

Who should tune in? As with short straddles, short strangles are best suited for traders expecting minimal movement from the underlying stock in the near term. However, this strategy comes shackled to boatloads of risk, so only those with a high risk tolerance need apply.

How does it work? Once the investor has singled out a stock, she would then simultaneously sell an equal number of slightly out-of-the-money puts and slightly out-of-the-money calls with the same expiration month. Typically, the underlying equity will be trading between the two strikes when the strategy is initiated.

By writing two options, the trader has significantly increased her profit potential, compared to just writing a single put or call. But, with the higher reward comes the higher risk (we’ll get to that in just a sec), which is why conservative investors may want to consider employing a different neutral strategy.

What’s in it for me? The short strangler’s goal is for the stock to remain between the two strikes at expiration, so both options expire worthless. The maximum potential profit is limited to the net credit received from selling the calls and puts.

There are two breakeven points for this position: the put strike minus the net credit received, and the call strike plus the net credit received.

What do I have to lose? Let’s just say that if we were researching a “sweet” vacation deal, this is where the timeshare jargon would appear… If the underlying security exceeds the lower breakeven point, your losses may be considerable, but are limited to the put strike less the net credit received. On the other hand, if the stock surpasses the upper breakeven point, your losses could be theoretically unlimited.

In addition, don’t forget to include any brokerage fees or margin requirements when calculating the total cost of this play.

Let’s look at an example.

Meet Willa, a seasoned options trader not afraid to roll the dice on a risky play. She’s had her eye on stock XYZ for quite some time, and thinks the shares will remain range-bound during the next few weeks. In an effort to capitalize on the stock’s stagnation, Willa decides to initiate a short strangle strategy.

The shares of XYZ have been sluggish on the charts lately, floating between support at the $47 level and resistance in the $53 region. With this in mind, Willa elects to sell an XYZ July 45 put for $1, or $100 (x 100 shares), and simultaneously sell an XYZ July 55 call for $2, or $200. The net credit on this short strangle would be $3, or $300, which is the most Willa stands to gain with this play.

The reason she chose shorter-dated options to sell was because of time decay, which is an option writer’s ally. The closer options expiration approaches, the faster the price of the sold options will erode. Then, if Willa decides to close her short strangle position before expiration, it should ultimately be cheaper for her to buy it back.

In order for this position to avoid a loss, the shares of XYZ need to remain between the $42 level (put strike minus net credit received) and $58 level (call strike plus net credit received) by expiration on Friday, July 17.

Short strangle on XYZ

In conclusion…

While the short strangle can be profitable, it doesn’t come without significant risks. Since the underlying stock must remain in a tight trading range before expiration, the success of this option play requires the investor to be accurate in her predictions.




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