What is the Short Strangle Options Strategy?

In this article, we will discuss

• An Overview of the Short Strangle Strategy
• Setting Up the Short Strangle
• The Key Price Levels in the Short Strangle
• The Short Strangle: An Example
• Important Things to Know About the Short Strangle
• Conclusion

Seasoned options traders not only aim to profit from large price swings in the underlying asset; they also have strategies that can leverage relatively stable markets. With Options B.R.O on the Samco trading, you too can trade like the experts with winning options trading strategies that are tailored for different market conditions. This is an advanced options strategy builder that analyses and suggests the best 3 strategies for any given market outlook.

However, to make an informed decision about the choices offered to you, it is essential to have a basic understanding of the different strategies available to traders. One such common options trading strategy is the short strangle, which is particularly useful for neutral, non-volatile markets.

An Overview of the Short Strangle Strategy

The short strangle strategy is a two-legged position that involves selling a call option with a higher strike price and selling a put option with a lower strike price. Since both the trades involve writing options, the strategy is labelled as the short strangle. Both the options used in this strategy have the same expiry date. The difference in the strike prices, however, makes the short strangle graph resemble its namesake.

A short strangle is different from a short straddle. Unlike the former, the latter uses two options with the same strike price. The short strangle is designed to offer you a net credit at the outset because you sell two options — and receive the premiums for these contracts. However, the strategy only remains profitable if the underlying asset’s price is highly stable till expiry. Any large price swings could render this strategy risky.

Setting Up the Short Strangle

Setting up the short strangle strategy is quite easy. You first need to establish that the price of the asset will likely not move (or move very little) by expiry. If your research points to these signs, you can execute this options trading strategy using the following trades:

• Trade 1: The Short Call

Here, you sell or write a call option with a strike price that is higher than the asset’s current price. This should be an out-of-the-money option.

• Trade 2: The Short Put

Here, you sell or write a put option with a strike price that is lower than the asset’s current price. This should also be an out-of-the-money option.

With Options B.R.O, Samco’s industry-first advanced options strategy builder, it becomes extremely easy to decide when this strategy works. Implementation is also a breeze because you can directly execute all the trades in the short strangle with just one click.

The Key Price Levels in the Short Strangle

Before you execute this neutral market strategy, you need to know what the potential outcomes and important price levels for this trade are. Check out the maximum profit, highest risk and break-even price points for the short strangle strategy.

• Maximum Profit:

This is a net credit strategy, as mentioned earlier. So, the maximum profit you can earn from this trade is the initial premium received (adjusted for any commissions and margins).

• Maximum Loss:

The maximum loss can be high on the downside since the price of the underlying asset can theoretically drop to zero. On the upside, however, it is unlimited since the asset’s price can increase indefinitely.

• Break-Even Prices:

Since the short strangle strategy has significant risks on both sides, it has two break-even price points, as determined by the following formulas:

Downside Break-Even Price = Short Put’s Strike Price — Net Premium Received

Upside Break-Even Price = Short Call’s Strike Price + Net Premium Received

By knowing these break-even points, you can set the stop-loss limits as required and limit the losses on both sides of the trade.

The Short Strangle: An Example

Let us now discuss a hypothetical example of this neutral options strategy to give you more clarity about how it works and what the potential outcomes may be. Assume that a stock is currently trading at Rs. 910 and you expect its price to remain quite stable over the next few weeks. So, you execute a short strangle strategy to make the most of this neutral market that you foresee.

This means you implement the following trades:

• The Short Call

Here, you sell one lot of OTM call options with a strike price of Rs. 920 and earn a premium of Rs. 23 per share.

• The Short Put

Here, you sell one lot of OTM put options with a strike price of Rs. 900 and earn a premium of Rs. 24 per share.

So, the net credit at the outset is Rs. 47 per share (i.e. Rs. 23 + Rs. 24). If the lot size is 100, the net opening credit becomes Rs. 4,700. Now, let us decode the different possible outcomes from this trade setup depending on how the market moves.

• Scenario 1: The Stock Price Remains Stable

Suppose that the market behaves the way you expected it to and the stock price remains stable at expiry, at around Rs. 912. In this case, here is how the two trades will work out:

• Short call with Rs. 920 strike: Expires worthless

• Short put with Rs. 900 strike: Expires worthless

This means you earn the maximum profit possible from the trade, which is the net premium received i.e. Rs. 4,700 (adjusted for costs of trading and the margin).

• Scenario 2: The Stock Price Falls Below the Put Strike Price

This is a risky scenario that could lead to substantial losses. Say there is an unexpected market development and the stock’s price declines sharply at expiry, to Rs. 850. The outcomes of the two trades will be as follows:

• Short call with Rs. 920 strike: Expires worthless

• Short put with Rs. 900 strike: Results in a loss of Rs. 50 (i.e. Rs. 900 — Rs. 850) per share, leading to a total loss of Rs. 5,000 (i.e. Rs. 50 x 100 shares)

So, the net result from the trade after adjusting for the premium credit will be a total loss of Rs. 300 (i.e. Rs. 5,000 — Rs. 4,700). The lower the stock price at expiry, the greater this loss will be.

• Scenario 3: The Stock Price Rises Above the Call Strike Price

The risk on this side is potentially unlimited. So, for the sake of our example, say the company announces quarterly results with profits above the expected levels, leading to a steep price increase. At expiry, the stock closes at Rs. 980. The outcome of the two trades in the short strangle strategy will be as follows:

• Short call with Rs. 920 strike: Results in a loss of Rs. 60 (i.e. Rs. 980 — Rs. 920) per share, leading to a total loss of Rs. 6,000 (i.e. Rs. 60 x 100 shares)

• Short put with Rs. 900 strike: Expires worthless

So, the net result from the trade after adjusting for the premium credit will be a total loss of Rs. 1,300 (i.e. Rs. 6,000 — Rs. 4,700). The higher the stock price at expiry, the more this loss grows.

Important Things to Know About the Short Strangle

In addition to the key profitability and loss levels and the possible outcomes, you should also be aware of a few other important aspects of this strategy. Let us delve into these aspects.

• Time Decay

This options trading strategy is set up to benefit from time decay. If the market is relatively stable, the time decay or theta decay can work in your favour.

• Volatility

High implied volatility may be risky for your position. While it may drive the premium up, a high IV after the position has been opened could lead to additional margin calls.

• Strategy Adjustment

You can adjust a short strangle by rolling one of the trades upward or downward depending on how the stock price changes with time.

• Risk Management

Since the upside and downside risks in this strategy are substantial, you must set strict stop-loss orders to prevent massive losses from unexpected price movements.

Conclusion

The short strangle strategy is one of the easier trading techniques for options traders. If you are new to F&O trading and want to take advantage of a potentially stable market, this strategy may be one of the most suitable options for you. However, to ensure that you choose the most appropriate trading strategy, you can rely on Options B.R.O.

In this advanced options strategy builder, you can analyse various aspects of an options trading strategy before you decide whether or not to implement it. These aspects include the short strangle graph, payoff chart, probability of profit, maximum profit and loss, risk-reward ratio and the strategy’s Greeks.

By performing such in-depth analysis, you can make a smarter decision about the best options trading strategy for any given market condition — whether it is bearish, bullish, volatile or neutral.

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