A short strangle is an options trading strategy. It involves selling a call option and a put option on the same underlying stock with the same expiration date. A short strangle enables investors to try to profit from a stock's volatility through the options premium income they received in the trade.
What is it?
Understanding the short strangle
A short strangle is an options trade to earn income on a stock that trades in a relatively narrow range. It has two parts:
- A written call option
- A written put option
The options are on the same underlying stock and have the same expiration date. However, they have different strike prices, unlike a short straddle, which has the same strike price. The call strike price is above the stock's current price, and the put strike price is below the call option and the stock's price.
For example, if a stock trades at $100 a share, you'd write a call option striking at $101 or more and a put striking at $99 or less. Investors can set up a short strangle on a stock they own (a covered short strangle) or on one they don't own (an uncovered or naked short strangle).
Risks
What are the risks of a short strangle?
The risk profile of a short strangle depends on many factors, including the underlying stock and whether it's a covered or uncovered trade.
An uncovered strangle (i.e., where the investor doesn't own at least 100 shares of the underlying stock or have enough cash to cover their puts) can theoretically have unlimited risk. If the underlying stock soars well past the call's strike price (and the option premium received), the investor must pay money to close the call option.
Meanwhile, if the stock craters and the investor doesn't have enough cash in their account to cover the trade, they'd need to use margin, potentially putting them at risk of receiving a margin call.
However, a covered short strangle (i.e., where the investor owns at least 100 shares for each covered call they write and has enough cash to cover their puts) isn't quite as risky. For example, if the underlying stock were to soar, the broker would call away the shares covering the trade. While the investor would miss out on the upside, that's the trade-off of this trade.
Conversely, the investor would get put shares (i.e., they'd be required to buy 100 shares for every put they wrote) if the stock price were to plunge. They could then wait for a recovery, potentially writing call options to chip away at the loss.
Why use them?
Why do investors use short strangles?
Investors use a short strangle to generate options income on a stock they believe will be range-bound. The maximum profit of the trade is the options income received (plus any profit on the stock if it's a covered strangle).
The goal of a short strangle is for the stock to close between the call and the put strike price at expiration. That would enable the options trader to keep 100% of the premium income. However, the trade would still be profitable if the stock didn't close higher than the strike price plus the combined options premium.
For example, if you wrote a $110/$95 strangle on a stock that generated a combined $2 in options income, the trade would still be profitable if the stock closed between $112 and $93 at expiration. The $2 per share in options income is the maximum profit an investor would earn on this trade.
Example
An example of a short strangle
Covered short strangles can be a great way to generate income on a stock you already own and wouldn't mind buying more if shares declined in value. For example, let's say an investor believes that shares of Apple (AAPL 0.64%) will stay within a rather tight trading range. They want to profit from this thesis by writing a covered strangle on the 100 shares they own.
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Shares traded at around $170 in early 2024. They decided to write one call option that expires in three months, striking at $180 and receiving $450 in premium income from the option. They also write one put option with the same expiration date, striking at $160 and receiving $380 in options premium income.
They have more than enough cash in their account to cover the value of the written put ($16,000). They received $830 in total options premium income, their maximum profit on this trade. If Apple closes between $188.30 and $151.70 a share at expiration, the trade ends profitably, earning full profits if Apple closes between $180 and $160 per share.
However, if Apple closes above $180 a share, they'd see their shares called away (unless they closed their short call before expiration). And a close of less than $160 would force them to buy another $100 shares (unless they closed the put ahead of expiration).
