What is a Short Strangle and Why would you place one?

What is a Short Strangle and Why would you place one?

It is important to understand how a short (naked) call and a short (naked) put work before you commit to placing your first strangle.

Why? Well because a strangle is basically the same as selling either a short call or a naked put as far as risk goes and how the trade works.

So, what is a short strangle?

You place a strangle by selling a call and a put at the same time with the same expiration. The short call and short put will have a different strike price, otherwise it would be a straddle which we will discuss another time.

Ideally, you want to place a strangle when volatility is high because you get the highest premium for your risk. This is normally the case when you are using a strategy that involves selling options.

There are thousands of strategies used to place strangles but I prefer a probability based strategy when implied volatility is high.

I like to sell my strangle at less than 30 days out, preferably at about 14 days, because of the effects of time decay. Time decay is what you are selling.

Ideally, I like to have an 80% or greater probability of success. I use the TDAmeritrade ThinkorSwim platform to get my probabilities. If you don’t have access to that the you can use the Delta of the option to get a rough estimate of probability.

Right now AAPL is trading at $317.68.

If I sell the $355 Call and the $280 Put with about 14 days until expiration I can bring in a premium of about $2.50 or $250.00 per contract. I will need about $3,500.00 in cash to secure this position so this is about a 7% return over 14 days with a 90% probability of success.

I can reduce my probability of success and increase my return by selecting a Call or Put closer to the current price.

I can even skew my strangle up or down by moving either the Call or Put closer in and moving the other further out.

You can also greatly increase your odds of success by setting a close order at less than the total premium received. If you sold the strangle above at $2.50 you might try to close it a 60%, 50% or 40% of the premium received. This increases your odds of a successful strangle. It decreases your return, but you can place more trades over the course of the year so it evens out.

Remember:

  1. With a short call your only risk is if the underlying price goes above your short call strike price. With a strangle you have both upside and downside risk.
  2. With a short put your only risk is if the underlying price goes below your short put strike price. With a strangle you have both upside and downside risk.
  3. Your overall risk, although to both the upside and downside, is the same as if you just placed a short call or a short put. The advantage the strangle gives you is that you can make twice the premium (more or less) as compared to just placing a short call or short put without increasing your risk.
  4. Unless you are purposely trading an earnings strategy with your strangle stay away from strangles that go through earnings.
  5. Try to trade strangles on stocks that rarely have significant news events. Stay away from pharmaceutical and other drug companies. Look for companies like UPS, FEDEX, LOW, HD, MSFT or AAPL. There are lots of other good ones, I just wanted to give you an example.

 

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