This technique is profitable if the stock price and volatility stay stable during the option's term.
The short strangle technique involves selling a call and a put with the same expiration date but with the call strike price greater than the put strike price.
Typically, when the technique is launched, both options are out of the money.
The investor is hoping for a stable stock price during the option's term.
This technique is more likely to work if the stock price and volatility stay stable during the option's term.
Earn money by selling premiums.
This strategy is distinguished from a straddle by the fact that the call strike is higher than the put strike; in general, both the call and put are out-of-the-money and near to equidistant from the underlying when begun.
- Short 1 AAPL 165 call
- Short 1 AAPL 155 put
Received a net premium
LOSSES ARE LIMITED TO THE MAXIMUM
Strangles earn less premium than straddles, but require a greater move in the underlying stock to suffer a loss.
The gut is another variation on this technique, in which the call strike is lower than the put strike.
Due to the fact that both the call and put strike prices of a gut are often in the money, at least one of them must be, this approach is extremely costly and hence rarely employed.
The maximum loss is unlimited. The maximum loss occurs if the stock goes to infinity, and a very substantial loss could occur if the stock became worthless. In both cases the loss is reduced by the amount of premium received for selling the options.
Gains are quite restricted.
The maximum gain occurs if the underlying stock remains between the strike prices. Both options will expire worthless in this situation, and the investor will retain the premium paid for selling the options.
Profitability is constrained by the premium paid for selling the options.
Potential losses are unlimited on the upside and very substantial on the downside.
This technique is profitable if the stock price is either above or below the call strike price by the amount of premium earned originally at expiration.
At either of those levels, the intrinsic value of one option will match the premium obtained for selling both options, while the other will expire worthless.
Breakeven point on the upside equals call strike plus premiums received
Breakeven on the downside = put strike - premiums received
Increased implied volatility would have a significant negative impact on this approach, all other factors being equal.
Even if the stock price holds steady, a quick rise in implied volatility would push up the value of both options and force the investor to put up additional margin in order to maintain the position.
The passage of time, all other things equal, will have a very positive impact on this strategy. Every day that passes without a move in the stock price brings both options one day closer to expiring worthless.
Early assignment, while possible at any time, generally occurs for a call only when the stock goes ex-dividend or for a put when it goes deep in-the-money.
Additionally, bear in mind that a circumstance in which a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off, or special dividend, may radically deviate from usual expectations for early exercise of stock options.
Risk of Expiration
An investor cannot know for sure whether or not they will be assigned on either the call or put until the Monday after expiration. If an assignment occurs unexpectedly, they will find themselves long or short the stock on the Monday following expiration and subject to an adverse move in the stock over the weekend.
This technique is essentially a race against time decay and volatility.
Volatility is the storm that can strike at any time and generate catastrophic losses.
The passage of time is a constant that brings the investor every day a little closer to realizing their anticipated profit.