To construct a short strangle option strategy, you simultaneously sell a call option and a put option with the same expiration date but different strike prices. This strategy is designed for investors who anticipate minimal price movement in the underlying asset.
How to Construct a Short Strangle Option Strategy
A short strangle involves opening two separate positions: selling an out-of-the-money (OTM) call option and selling an out-of-the-money (OTM) put option. Both options must share the same expiration date.
Understanding the Core Components
The primary goal of a short strangle is to profit from the time decay of options (theta) and a stable underlying asset price. You collect premium upfront from selling both options.
- Selling a Call Option: You sell a call option with a strike price above the current market price of the underlying stock. This is known as an out-of-the-money (OTM) call.
- Selling a Put Option: You simultaneously sell a put option with a strike price below the current market price of the underlying stock. This is an out-of-the-money (OTM) put.
- Same Expiration: Both the call and put options must have the exact same expiration date.
Step-by-Step Setup
To execute a short strangle:
- Identify an Underlyer: Choose a stock or other asset that you expect to trade within a relatively narrow range until the options' expiration.
- Determine Expiration: Select a suitable expiration cycle for both options.
- Sell the Call:
- Action: Sell-to-open (STO) a call option.
- Strike Price: Choose a strike price that is above the current stock price.
- Sell the Put:
- Action: Sell-to-open (STO) a put option.
- Strike Price: Choose a strike price that is below the current stock price.
Example Scenario
Let's illustrate with a practical example:
Suppose a stock, XYZ Corp., is currently trading at $100 per share. You believe XYZ Corp. will remain relatively stable over the next month.
Here's how you would set up a short strangle:
- Sell Call Option: You sell-to-open an XYZ Corp. call option with a strike price of $105, expiring in one month.
- Sell Put Option: Simultaneously, you sell-to-open an XYZ Corp. put option with a strike price of $95, expiring in one month (the same expiration as the call).
You would collect the premium from both the $105 call and the $95 put. Your profit zone would be if the stock price remains between $95 and $105 (plus the premiums collected) at expiration.
Key Characteristics of a Short Strangle
| Feature | Description |
|---|---|
| Market Outlook | Neutral to moderately bullish/bearish, expecting limited price movement (low volatility). |
| Maximum Profit | Limited to the total premium collected from selling both the call and the put. |
| Maximum Loss | Potentially unlimited on the call side if the stock price rises significantly, and substantial on the put side if the stock price falls drastically. |
| Breakeven Points | Upper: Call strike price + total premium collected. Lower: Put strike price - total premium collected. |
| Time Decay | Beneficial, as the value of both options erodes over time. |
| Volatility | Benefits from decreasing volatility after the strategy is initiated. |
Why Use a Short Strangle?
Traders often use short strangles when they anticipate that the underlying asset's price will stay within a defined range. It allows them to profit from both time decay and the potential for a decrease in implied volatility. Because you are selling options, you receive an upfront credit, which is your maximum potential profit.
This strategy requires careful monitoring, as significant price movements can lead to substantial losses beyond the initial credit received.
