Short Strangle

Traders use a short strangle when they anticipate decreased market volatility and stable prices. By selling two out-of-the-money (OTM) options, they aim to earn the option premium. While the premium is lower than selling at-the-money (ATM) options, the likelihood of the options expiring OTM is higher.

I. Strategy Explained

1) Setup

「Sell Put」 + 「Sell Call」

A short strangle is similar to a short straddle, involving call and put options on the same stock with the same expiration date and contract quantity.

However, in a short strangle, the put’s strike price is lower than the call’s. Both options are typically out-of-the-money, with the put strike below and the call strike above the current stock price.

2) Breakdown

Potential profit: Your profit comes from the premium you earn upfront. However, if there is an in-the-money (ITM) option which is likely to be assigned, your profit could be reduced or turned into a loss.

Note: Maximum potential loss and profit for options are calculated based on the single leg or an entire multi-leg trade remaining intact until expiration with no option contracts being exercised or assigned. These figures do not account for a portion of a multi-leg strategy being changed or removed or the trader assuming a short or long position in the underlying stock at or before expiration.

3) Features of Strategy

Ideal conditions: Neutral outlook on the stock. Low expected volatility.

Limited Profit: When the stock price equals the strike price at expiration, both options are out-of-the-money, you can keep all the premiums received upfront. Maximum profit = total premium received.

Unlimited Loss: As the seller of both a call and a put, you incur a loss of premium or more whether the stock price rises or falls. The larger the price movement, the greater the potential loss.

Lower Volatility: This strategy benefits from low volatility. If the underlying asset's price changes significantly by the expiration date, it may incur unlimited theoretical losses. Therefore, it is more appropriate to construct when implied volatility (IV) is high and expected to decrease.

II. Case Study

TUTU will release its financial report next week. You’ve noticed that the implied volatility (IV) of TUTU options is relatively high. You believe that after the report is released, the IV will quickly decline due to reduced uncertainty, resulting in an "IV Crush."

Currently, TUTU's stock price is $50. Anticipating an IV Crush next week, you decide to use an options seller strategy. To increase the probability that the sold options will expire OTM, you sell two OTM options: a call with a $54 strike price and a put with a $46 strike price, creating a short strangle strategy.

With the decline in stock price volatility, the value of the options should also decrease. If the stock price remains unchanged or fluctuates within a narrow range, the total value of the options should decrease due to the erosion of time value (all other factors remaining equal), allowing you to potentially profit as an option seller.

Cost of setting up the position:

Net premium from the put option: $100 ($1 received per share).

Net premium from the call option: $100 ($1 received per share).

Net premium in total: $100 +$100=$200 ($2 received per share).

1) Scenario 1: Stock price remains relatively stable

The maximum profit is achieved when the stock price is between the put strike price and call strike price at expiration. In this case, both the call and put options expire OTM and are not exercised, allowing you to keep the full option premium of $200.

If the stock price is between the lower breakeven and the put strike price, the put is ITM and the call is OTM. You will be assigned the put, buying the stock at $46, which is higher than the market price.

If the stock price is between the call strike price and breakeven2, the call is ITM and the put is OTM. You will be assigned the call, selling the stock at $54, which is lower than the market price.

Although being assigned results in a loss (assuming the stock position closed immediately and no further loss incurred), it is smaller than the net income from the initial option sales, so the strategy is profitable overall.

If you prefer to avoid holding long or short stock positions due to assignment, you can close the position early. When the stock price fluctuates within a narrow range, the time value of the options typically erodes. This may allow you to buy back both options at a lower price and realize a profit.

2) Scenario 2: Stock price drops significantly

The call is OTM, while the put is ITM.

If assigned the put, you must buy TUTU stock at $46, which is higher than the current market price. The more the stock price drops, the higher the loss due to the assignment.

When the stock price drops below the lower breakeven of $44 ($46 strike price - $2 option premium received), losses begin to accrue. As the stock price continues to fall, losses generally increase.

To avoid further losses from a continued stock price drop, you can choose to buy to close the position. When the stock price drops significantly, although the call value decreases, the put value increases even more. At this point, you need to buy back both options at a higher net price to close the position, incurring a loss.

3) Scenario 3: Stock price rises significantly

In contrast to scenario 2, the call is ITM, while the put is OTM.

If assigned the call, you need to sell TUTU stock at $54, which is lower than the current higher market price. The greater the stock price increases, the higher the loss due to the assignment.

When the stock price rises above the upper breakeven point of $56 ($54 strike price + $2 option premium received), losses begin to accrue. As the stock price continues to rise, losses generally increase.

To avoid further losses from a continued stock price increase, you can choose buy to close the position. Similar to scenario 2, when the stock price rises significantly, although the put value decreases, the call value will increase even more. At this point, to close the position, you need to buy back both options at a higher net price, which incur a loss.

III. How to construct a short strangle on Futubull

If you don't have the underlying position, you can go to Options Chain > Tap on the Strategy tab at the bottom of the screen > Select Strangle.

Choosing Sell, the system will then automatically help you sell one put option and sell one call option, forming a short strangle.

IV. Applying the short strangle strategy

Core Strategy: Delta Neutral + Short Vega

Delta neutral means the strategy is neutral to market movements (rises or falls), while short Vega indicates an expectation of decreased volatility, i.e., anticipating stable market price and no significant price fluctuations, whether upward or downward.

This strategy is often used when anticipating a stock will shift from high volatility to a more stable state. As volatility decreases, you can potentially profit from the time decay of both the call and put options. This strategy is also appropriate when the stock price remains stable. However, options with low volatility have lower premiums, making investors generally unwilling to accept unlimited potential losses for relatively small premiums.

1) Company financial report

After a financial report is released, the stock price often experiences a significant rise or fall. Therefore, before the financial report is released, the IV of options is typically relatively high, as some people are willing to pay a higher price for options to speculate on a significant movement. However, after the financial report is released, the uncertainty surrounding the stock usually decreases, and the IV may quickly drop from its high point.

If you expect that the stock price movement after the financial report will be less than expected, you can consider constructing a short strangle to earn the premium from selling the options. However, keep in mind the risks involved with this strategy.

2) Major macro/political events

Major events like Federal Reserve interest rate decisions, CPI data releases, elections, and policy changes can cause significant stock price fluctuations, leading to high implied volatility (IV) of options.

If the market expects that no major events will occur in the short term, the IV will gradually fall back to its mean level, a phenomenon known as "IV Crush." Even if the option's expiration date and strike price remain unchanged, its price will likely decrease. Therefore, you can attempt to use a short strangle strategy to earn the premium from selling the options.

However, keep in mind that short options positions can also face substantial losses during major events, particularly if there's an unfavorable gap move in the underlying stock.

V. FAQs

Q. What are the differences between short strangle and short straddle in choosing strike prices?

The main difference between the two strategies lies in the choice of strike prices. A short straddle typically involves selling two ATM (at-the-money) options, while a short strangle usually involves selling two OTM (out-of-the-money) options.

To achieve delta neutrality, the strike price of the call and put options should be equidistant from the stock price.

The larger the difference between the call and put strike price, generally the easier for the stock price to remain within the profit range, but the premium received from selling the options will also be smaller. Conversely, when the difference in strike prices is smaller, the stock price is more likely to move in-the-money, leading to potential assignment losses, but the initial premium received is higher. When the difference in strike prices is reduced to 0, it effectively constructs a short straddle strategy. Therefore, a short straddle can be considered a specific type of short strangle.

The choice of strike price difference determines the distance between the two breakevens, so it is very important to estimate the future volatility of the stock price. You can refer to the Expected Move value to estimate the market's current expectations of stock price volatility, and choose the distance between the strike prices and the current stock price.

Q: Choosing the expiration date?

A: Most investors typically opt for shorter expiration dates because they aim to profit from short-term speculation. Options with longer expiration dates generally face a higher risk of significant stock price volatility due to unexpected events occurring in the interim.

Q: If the position shows a gain, how can we realize profits?

A: When a short strangle is already profitable on paper, it usually indicates that the stock price hasn't fluctuated significantly, and the option prices have experienced notable decay. To avoid the risk of sudden events causing drastic stock price movements, and to avoid ending up with long or short stock positions upon expiration, you can choose buy to close the short strangle position rather than holding it until the expiration date.

Q. If the stock price fluctuates significantly or IV increases, and the strategy incurs a loss, what measures can be taken?

A:

Method 1: Buy to close the position

When the fluctuation is significant, the increase in the price of the call or put exceeds the decay of the other option, causing the combined total value of the two options to rise. To avoid potentially unlimited losses, you can proactively buy to close the position before the expiration date. Although you will incur some losses by buying back the options at a higher price, you can avoid facing more significant potential losses.

Method 2: Roll the position

If the stock is a long-term favorite, you can buy to close the current position realize the gain or loss and then sell to open a position with a further expiration date.If the stock price falls below the put strike price and you remain bullish on the stock in the long term, you can let the sell call part expire worthless and suffer a loss, roll the sell put position before it's assignment or close the long stock position generated by the short put. You can continue to roll the sell put position and hold them to expiration continuously. If the stock does not fall below the put strike price, you can collect option premiums. Remember this strategy should only be considered if you remain bullish on the stock. If the stock price keeps on going down, you could just be compounding your losses.If the stock price rises above the call, since the risk above is unlimited, rolling the position may lead to greater losses, it may be prudent to stop loss and exit.

Q. How do I reduce the unlimited risk of a selling strategy?

A:

Method 1: short iron condor strategy

If you are concerned about the unlimited upward risk and significant downside risk, you can add two protective legs to the strategy by buying a lower strike price put and a higher strike price call, transforming the strategy into a short iron condor.When the stock price rises or falls significantly, the original short strangle strategy would incur unlimited losses. Now, with the addition of two protective legs, if the stock price rises or falls to the point where these two options are ITM, you can exercise the options to limit the maximum loss, thereby avoiding further loss risk.Although you need to pay some option premiums for this, the overall strategy's theoretical maximum loss is limited to a finite range.

Method 2: buy the underlying stock

In practice, the risk of stock prices rising is greater than the risk of falling because the upside potential is unlimited. If you are bullish on the underlying stock in the long term, you can consider buying the stock to hedge the upside risk.When the stock price rises and the put is OTM, buying the stock plus selling the call essentially forms a covered call strategy. If you purchase the stock at the same time as the short strangle and the price of the stock is equal to or less than the strike price of the short call, the stock you hold offsets the potential loss, allowing you to receive the full option premium.However, the stock will be called away and the downside risk is still not hedged, so this method is more appropriate for stocks that you are bullish on over the long term.