Options are great trading tools because they give you the means to benefit from almost any market environment. Whether you believe the market is going to rise or fall, move sharply or not at all, options can be a simple and low-cost way of positioning your portfolio to profit from forecasted market movements.
To find out more, check out our intro article on earning income with ETF options.
One options strategy that can be used to generate income is a strangle. An investor writing a strangle would sell a call option and a put option simultaneously and collect the options premiums. Strangles can be especially lucrative for income seekers, since they result in the receipt of two options premiums instead of one.
Using ETFs for Options Trading
Many stocks and ETFs have options available for trading. In practice, many traders choose to trade options on broad market or sector ETFs since they provide exposure to large segments of the market and tend to be more liquid. Highly liquid ETF options are preferable for investors because they help reduce transaction costs.
The SPDR S&P 500 Trust ETF (SPY ), with over 24 million contracts outstanding, is the most frequently traded and most liquid underlying options security. It has nearly three times as many open contracts as the next closest ETF, the iShares MSCI Emerging Markets ETF (EEM ). The iShares Russell 2000 ETF (IWM ), the SPDR Gold ETF (GLD ) and the PowerShares QQQ ETF (QQQ ) are other often-used securities for options trading.
The Short Strangle Strategy
A short strangle, also known as a sell strangle, involves selling an out-of-the-money (OTM) call and an out-of-the-money put simultaneously on the same underlying security with the same expiration date. The strike price can be determined by the options seller based on their risk preferences and income goals. Options with strike prices closer to at-the-money (ATM) yield greater premiums but have a higher probability of losing money. Conversely, options with strike prices that are further out-of-the-money have a lower premium yield but a greater chance of making money. Strangles have call and put options with different strike prices. A straddle, in comparison, involves selling call and put options with identical strike prices.
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Profits and Losses Using Strangles
A short strangle would be implemented by those anticipating little volatility in the price of the underlying security. A short strangle is most profitable when the stock price remains between the two strike prices. The loss potential of a short strangle is unlimited. Losses increase the further the share price moves away from the strike price of the options.
For example, a trader wishes to sell a strangle on a stock that is trading at $40 per share. He sells one call with a strike price of $45 and one put with a strike price of $35 for $1 each. Since each contract covers 100 shares, the trader nets $200 in options premiums for the entire trade.
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If the stock price remains between $35 and $45 through the expiration date, the trader earns the maximum $200 profit as both options would expire worthless.
If the price of the stock drops below the strike price of the put, down to $30, for example, the call expires worthless but the put becomes in-the-money (ITM). In this scenario, the put would be worth $5 at expiration resulting in the trader losing $500 on the put but still earning the $200 in options premium for a net loss of $300.
A stock price above the strike price of the call would yield a similar result. The put would expire worthless but the call would become in-the-money. If the stock price rose to $50, the trader would lose $500 on the in-the-money call but retain the premiums for the options sold. The net result of this trade is also a loss of $300.
Since there is no limit on how high a stock price can rise, there is also no limit to how far in-the-money the written call option could be. Given this, a short strangle has unlimited loss potential.
The Benefits of Technical Analysis with Strangles
Technical analysis can be a great way of trying to determine when the market has the potential for being more volatile than normal. Technical indicators study past stock price movements and trading volumes in order to forecast future market movements. Traders who sell strangles will want a technical indicator that forecasts a less volatile market in order to increase the chances of writing a profitable strangle.
The Bollinger Bands not only help forecast market price movements but can also help predict volatility. The calculation for the Bollinger Bands takes a simple 21-day moving average and uses the data points within that time frame to calculate share price values two standard deviations from the average on either side. A move toward the upper band would be a bearish signal and a move toward the lower band would be bullish.
The width of the bands indicate the level of volatility. A wide range between the two bands suggests a volatile market while a narrow range would indicate a calm market. Traders looking to implement a short strangle would want to do so when the band range is narrow, increasing the likelihood that the two written options would expire out-of-the-money.
The Risks of Writing Strangles
The primary risk in taking a short strangle position is that the markets become volatile. Any kind of unexpected news announcement can send the markets moving sharply in either direction at a moment’s notice. Each of the written options has risk. The put option could lose the entire price per share of the security minus the option premium should the share price go all the way to zero. The call option has unlimited loss potential since the share price has no upper bound.
The Bottom Line
While options have the potential for being risky, using option-writing strategies to produce income can actually be relatively conservative and a good way of producing a synthetic yield higher than what can typically be earned in the fixed-income markets. The potential for earning two options premiums is a plus, but the risks that arise from potential volatility in either direction can be a drawback of a short strangle.
To learn more about specific options trading strategies, check out the rest of our ETF Options Income Series: