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neutral strategies

Short Strangles

Analyzing the risk profile of a short strangle

Risk Profile & Summary

Standard Setup

The standard setup for a strangle is to simultaneously
an
and an OTM
on either side of the current share price for a net credit. Usually, the
have a
of similar magnitude, and are somewhere between 16-30∆. In the example below, we sold the 30Δ strikes on either side of the share price for a total of $1.40:
Risk Profile: 30x30 Delta Strangle

How It Works

Short strangles profit off of decaying option value. In other words, they profit when option prices decline. They lose when option prices rise. Options' values can decay the most when they are
declines
and
draws closer (
Therefore, a strangle has the most profit potential when the share price is between the two
strikes as shown by the green profit zone in the image above. If one of the strikes moves too far
the trade will lose profit potential because it will have taken on
which does not decay. If the strangle takes on more intrinsic value than the credit collected, the position will be incapable of profit (as indicated by the red zones) unless the share price reverts back to the green zone.
The most that can be made on a short strangle is the credit received. Narrower strikes will bring in a greater credit, but will result in a smaller profitable range and have a lower probability of profit. Skewing the strikes to establish a directional bias may also bring in a larger credit in exchange for a lower probability of success. Wider strikes bring in a smaller credit but create a larger profitable price range and a higher

Why We Do This

Short strangles are one of the most versatile and powerful option strategies there are. They can offer excellent control over
Using strikes equidistant from the current share price, strangles can provide market exposure without taking a directional bias – in other words, they can be established with a
Neutral strategies come in handy when you have no strong opinion or simply do not care which way the share price moves. As long as the strategy does not take on a greater instinsic value than the credit received, it can profit. If you personally have a directional bias that you'd like to maintain, strangles also have the capability of being skewed one way or the other. We will cover how skewing works later in this article.
Short strangles also provide one of the most effective and efficient ways to capitalize on the decay of
If both strikes are placed
the spread will be made up of pure
If we believe risk perception is at a high (as measured by
and about to decline, a strangle can be sold to make money as premium decays. Premium decays naturally as time passes and is accelerated by declining IV. Please revisit Pricing Options: Intrinsic & Extrinsic Value and Pricing Options: Time if you need a refresher on extrinsic value and premium decay.

The Risks

All the risks of a short strangle boil down to one factor: volatility. Strangles can lose money if:
  1. Implied volatility increases too much after trade entry
  2. The share price is overly volatile and moves too far past one of the strikes
If implied volatility were to expand after a short strangle has been sold, option prices will rise due to increased extrinsic value. This would negatively impact your P/L, even if the share price remains in the green profit zone (as shown below). As long as the share price stays within the green zone, however, the extrinsic value will decay by expiration and result in profit.
Figure 1
Note: Remember that the total extrinsic value in a risk profile is represented by the distance between the blue-bordered circle and the solid black line. Revisit How to Read a Risk Profile (Page 6) if you'd like a refresher.
Another losing scenario would be if the share price moves too far in either direction as shown below. Short strangles carry risk on both sides of their profit zone. Should the share price breach one of the strikes, that strike would begin to take on intrinsic value. If the intrinsic value exceeds the total credit collected at trade entry, the position will not be capable of profit. In this case, the only way to profit without taking defensive action would be if the share price reverted back towards the green profit zone.
Figure 2
Lastly,
risk is a factor in any strategy including neutral strategies like the short strangle. The strangle may start off neutral, but will become directional as the share price changes. Due to the opposing call and put, the strategy moves
to the market. As the share price rises, the
causes the strangle to take on negative delta, making it
As the share price falls (as in the example above), the
causes the strangle to take on positive delta, making it
Keep in mind that short strangles carry
There is no predetermined limit to the amount of losses that can be incurred. Therefore, it is extremely important to only place strangles in products small enough that large swings outside the profit zone won't blow up your account.

Summary

Assumption Neutral/Adaptable
At trade entry, short strangles are usually thought of as neutral strategies which means they can profit if the share price moves higher, lower, or stays the same as long as it falls within a specific range. They are, however, adaptable strategies and can be skewed in any direction to fit the traders assumption. Their directional risk can also change depending on how the share price moves.
Cost Basis Credit
The cost basis for a short strangle is equal to the total credit received.
POP Moderate to High
A short strangle typically has a higher than 50% probability of profit. Depending on the width and placement of the strikes, they can range from around 50% to as high as 80% or more.
Capital Requirement Moderate
In a
short strangles generally require less capital than long shares. The more expensive or volatile the
is, the higher the capital requirement will be.
Break Even (before commission and fees) Short strangles have two break-evens. The lower b/e is calculated by subtracting the total credit received from the put strike. The upper b/e is calculated by adding the credit received to the call strike.

Lower B/E = Put Strike - Credit

Upper B/E = Call Strike + Credit
Maximum Profit Credit Received
The most you can make on a short strangle is the amount you sell it for.

Max Profit = Credit × 100
Maximum Loss Undefined
Short strangles have undefined risk meaning there is no limit to how much you could potentially lose. Be extra cautious about your position size when dealing with undefined risk.
Capital Allocation (per position) 3-5% Max
Depending on account size, 3-5% of
is the maximum amount of
I would allocate to a short strangle position.
Profit Target 50%
The goal is to cash out early with around 50% of the maximum profit.
Delta (P/L rate of change) Dynamic
Short strangles carry dynamic delta which means their delta will change as the share price changes. As the share price moves higher, the strangle's delta will decrease and eventually become negative (bearish). As the share price moves lower, the strangle's delta will increase and eventually become positive (bullish).
Theta (Time decay) Positive
Short strangles carry positive theta which means they profit off the passage of time.
Vega (Implied volatility sensitivity) Negative
Short strangles carry negative vega. This means they benefit from decreases in
and are disadvantaged by increases.
Gamma (P/L Momentum) Negative
Short strangles carry negative gamma which means their delta decreases (or becomes more negative) as the share price rises. Inversely, it rises (becomes more positive) as the share price falls. In practical terms, this means that the position will slow down as it profits and accelerate as it loses.

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