A short strangle consists of selling call and a put option in the same underlying security, strike price, and expiration date. Point A represents the selling of the put and point B the sale of the call on the chart below. With a short strangle, credit is received and reaches maximum profit when the stock stays within the range of the two strike prices. The profit opportunity of a short strangle is limited to the total premiums received. This strategy works best when the stock has little movement until the expiration.
The investor will receive his maximum win if the stock finishes within the strike prices at expiration, meaning the investor will win both the call side and the put side, keeping the full premium of both positions. However, if the stock does have a significant move, this will hurt the investor.
Profit/Loss
Maximum Gain = Net Premium Received
The maximum loss for a short strangle strategy is unlimited as the stock can continue to move against the trader in either direction.
Breakeven
The breakeven on the top side of the strangle is calculated by adding the premium to our call strike price and on the downside subtracting the premium from the put strike price.
Lower Breakeven = Put Strike Price – Premium Received
Upper Breakeven = Call Strike Price + Premium Received
Example
If a trader executes a short strangle at the following prices:
- Sell 1 XYZ 105 call at 2.20
- Sell 1 XYZ 95 put at 2.30
- Net credit = 5.50
If the stock stays within the 95 to 105 range then then the trader would keep the full $5.50 and achieve their maximum gain.
If the stock trades up to $112, then the trader would lose $7 on the 105- strike price call, but because they received $5.50 on the strangle, they would have a net loss of $1.50.
Conclusion
This is a market-neutral strategy, which makes the most sense when there is no major announcement or earning scheduled. A trader who wants to executes a short strangle wants the stock to stay relatively stable with little price movement during its duration, but wants to give themselves more flexibility vs. a short straddle.
Traders like to sell strangles so that they receive two premiums, requiring the stock to have to move twice as far in either direction before they would start to lose.
Time decay is working for the investor as they are looking for both options to expire worthless, as time goes on this position decays away, and the position rapidly profits as long as the stock does not have any sharp moves.
Because this trade does have unlimited risk, it’s recommended to be very selective when executing a trade like this and to keep quantity sizing small.
