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Short Strangles

Analyzing the risk profile of a short strangle

Inverted Strikes

Normally, a strangle is made up of one short put at a lower strike, and one short call at a higher strike. When the share price is between both strikes, both options are OTM and can expire worthless, allowing for maximum profitability. When a short put has a higher strike than the short call, on the other hand, it is referred to as an inversion. When this happens, there is no situation where both strikes may expire OTM. No matter where the share price lands, you will always have at least one strike ITM. In other words, inverted options will always carry intrinsic value. The minimum intrinsic value it holds is equal to the difference between the two strikes. That means, the lowest debit you could possibly pay to close the position is the width of the inverted strikes.
Most often, inverted strangles are not placed as opening trades but are the result of defensive trading. We will not cover defense quite yet, but I wanted you to have the ability to recognize an inversion and understand what it means should you ever come across it. While very uncommon, it is possible to sell an inverted strangle as an opening trade which I will demonstrate in the risk profile below:
Risk Profile: Inverted 70x70 Delta Strangle
You may have noticed that this profile looks almost identical to the original strangle. From a magnitude-of-risk perspective, they actually are. You can profit or lose just as much as you can with the original strangle. There are, however, a few key differences...
  1. Inverted strangles will sell for a much larger credit to account for intrinsic value:
    Remember that this trade has a minimum intrinsic value equal to the width of the strikes – in this case, $4. Add to that the $1.40 of extrinsic value and you would end up receiving a $5.40 total credit for placing this trade.
  2. The most you can make is the credit, minus the intrinsic value
    Just like a normal strangle with OTM strikes, the most you can make is equal to the extrinsic value – in this case, $1.40. This is because the lowest price you will ever be able to close this spread for is $4, the minimum intrinsic value.
    ($5.40 total credit) – ($4.00 intrinsic value) = $1.40 Max Profit
  3. Risk of poor liquidity
    One of the biggest problems you might run into with ITM options is poor
    ITM options tend to have much
    than OTM options. This could make getting in and out of the trade for a fair price much more difficult.
  4. Assignment risk
    While assignment won't affect your total risk on the position, if you were to be assigned on one of your ITM options, it could significantly consume
    This can be problematic from a
    perspective, especially for small account sizes. There can also be other headaches that come along with assignment of short shares in particular, such as
    payments,
    charges, etc.
  5. Complexity
    Lastly, it will not only be inevitable, but common to play defense throughout your entire trading career. Inverted options can make defensive decisions much harder for a number of reasons. Wide markets, tracking intrinsic and extrinsic value, balancing
    and other factors all serve to make inverted strangles feel complicated and hard to manage.
The moral of the story is, since inverted strangles create a number of complications and offer zero advantages over normal strangles, it makes no sense to sell one at trade entry. You may wind up with one as the result of defending a losing trade, however, you probably wouldn't want to start off with one. Also, for your information, inverted strangles can eventually lose all profit potential if the strikes are wide enough. Just as an example, let's imagine that, somehow, you wind up with a $4-wide inversion and have only collected a total of $2.00 in credit. Since a $4 debit is the best you can hope close the trade for, it means your best case scenario is a $2 loss:
($2.00 total credit) – ($4.00 intrinsic value) = $2.00 Loss
The risk profile might look something like this:
Figure 12

What Happens at Expiration

Finally, let's imagine we hold an inverted strangle all the way until expiration. What would happen? That would depend on the position of the share price.

The Share Price is Below the Call

If the share price is below the call at expiration, the call will be OTM and expire worthless. The put, however, will be deep ITM and assigned 100 long shares at the strike price. You would find 100 long shares in place of the strangle by the next business day.

The Share Price is Above the Put

If the share price is above the put at expiration, the put will be OTM and expire worthless. The call, on the other hand, will be deep ITM and assigned 100 short shares at the strike price. You would find 100 short shares in place of the strangle by the next business day.

The Share Price Lands Between the Strikes

If the share price lands anywhere between the strikes at expiration, both options will be in the money and assigned. This means you will be required to buy 100 shares at the higher put strike, and sell 100 shares at the lower call strike. Since the strikes cancel each other out in this scenario, the position would disappear completely from your portfolio by the next business day.

Please Revisit This Section Later, If Necessary

Inversions tend to be one of the hardest concepts for both new and experienced traders to grasp because there are so many moving pieces. Comprehension also relies heavily on a clear concept of intrinsic vs. extrinsic value as you've probably noticed. Please, if you need, revisit this section down the road as the picture becomes clearer to you. This is one of the most advanced topics we have to cover, and full comprehension is not vital to keep moving forward. I simply want you to be aware of this type of scenario because it will eventually become important once we get into defensive strategy.

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