Options Theory: Short Strangles
Buying low and selling high is the path to victory on Wall Street. It’s a simple concept, yes, but one that many find challenging to employ. The principal problem is your emotions. Rising prices make you giddy and thus, less desirous to sell. Falling prices make you scared and therefore less likely to buy.
Fortunately, there are many ways to combat your wacky wiring. One method is to use a strategy that is designed to buy dips and sell rips automatically. It’s known as the short strangle and is the twin to the long strangle trade outlined last week.
If you take every characteristic of the long strangle and flip it on its head, then you’ll discover the traits of the short strangle. It’s a neutral, short volatility trade. In Greek speak we say it’s a delta neutral, negative vega trade. Additionally, it profits from time decay and exposes you to negative gamma. More on these in a minute, but first let’s make sure we understand the position’s structure.
A short strangle involves selling an out-of-the-money call, and out-of-the-money put simultaneously. Consider it a bet that the stock will remain rangebound and that both options will expire worthless. Since a short call obligates you to sell stock, the trade gets you short as the market rises. And since a short put obligates you to buy stock, you will get long as the market falls. This is the negative gamma component. Here’s an example:
XYZ @ $100, implied volatility is high (read: options are expensive)
Sell a one-month $55 call for $1.00
Sell a one-month $45 put for $1.00
Net Credit $2.00
The total credit represents the max reward and will be captured if XYZ remains between $45 and $55. Let’s think about the potential outcomes if the stock rises or falls. If XYZ is above $55 at expiration, the short call will be assigned resulting in you shorting the stock at the strike. But because you received a $2 credit, your actual cost basis will be $57 for the short stock trade.
Alternatively, if the stock plunges below $45, your short put will be assigned resulting in you buying the stock. Again, due to the $2 credit received your true cost basis will be $43.
Those are your worst-case scenarios: short the stock at $57 or long at $43. This is what I’m talking about when I say the short strangle gets you long at lower prices and short at higher prices. If you believe that a dip towards the low $40s will be temporary and the stock will eventually recover, then perhaps buying near $43 isn’t a bad idea. And, on the flipside, if you think a rise towards the upper $50s will be short-lived and the stock will eventually drop back toward $50, then shorting at $57 isn’t that bad an outcome.
This is one reason why I’m a fan of the short strangle. It puts you in a position that accumulates bullish exposure at lower prices and bearish exposure at higher prices. It’s a default posture that I think serves traders well.
The higher the implied volatility at trade entry the better. That’s because your profit is limited to the premium received and the premium received is a function of how elevated volatility is.
As for the cost of the trade, it comes down to how much your broker makes you set aside when you sell naked options. Typically it’s around 15% to 20% of the stock price which is why most traders prefer to sell these on cheaper stocks. $50 to $60 is a reasonable upper limit, but it really comes down to personal preference.
Profit Target
If the stock cooperates and remains in the range, you could ride to expiration and let both options expire worthless. An alternate technique which increases your probability of profit is to exit early. I like the idea of buying back the call or put ASAP once you’ve captured the bulk of your gains. So, if I sold each option for $1.00 apiece, then I might close them at 20 cents. Also, even though you sell both sides simultaneously, you can buy back the call before you buy back the put and vice versa.
Stop Loss
If the stock misbehaves by rallying or falling too far, you could close the losing side (call or put) when your strike price is reached. That will minimize the damage. Or, you could ride to expiration and give the stock a chance to return to the profit range. Or, you could allow assignment and end up buying or shorting the stock at your cost basis. Then manage it as you would a stock position.
The variations of management are myriad and will be developed over time as you become more familiar with each one’s pros and cons.
