Experienced options investors looking for a cost-efficient way to generate income in stable markets may consider the short strangle strategy. The options writing strategy carries elevated risk, seeking to benefit from expectations of stocks remaining rangebound.
“Traders may use a short strangle when they believe a stock or ETF will remain relatively neutral,” BMO explained in a video. Short strangles are also useful “when they think the options market is pricing in a level of future volatility that won’t come to pass.”
A short strangle entails writing (or selling) a put and a call option on an underlying asset. The options contracts have the same expiration date but have different out-of-the-money strike prices. A call gives the buyer the right, but not the obligation, to purchase an underlying asset at the strike price by the expiration date. A put gives the buyer the right to sell an underlying asset at its strike by expiration. Option writers are paid premiums in return for taking on the risk that the option becomes in-the-money and exercisable.
This credit strategy benefits when prices remain rangebound between the two strike prices and expire unused. They also profit to a lesser degree should prices rise above the strike price but less than the total amount of the premiums earned. Alongside the confined return potential, the strategy carries elevated risk. Let’s look at an example to demonstrate how this works.
Stock ABC currently trades at $125. While markets anticipate strong price movement in the next few weeks, a trader believes the stock will remain stable. The trader writes (sell) a call option at $130 with a premium of $5 while simultaneously writing a put option for $120 with a premium of $5. Both options expire in four weeks.
The credit strategy earns $10 from the short strangle upfront. Should prices fail to reach $130 or fall below $120, the options expire. Plus, the trader keeps the $10 in premiums. However, should prices cross the strike, the trader’s profit will remain strong, and they will lose money.
It’s important to note that the premiums allow for a $10 cushion on either side of the strike price. If stock ABC reaches $135, the put option expires unused, but the call value is $5. This leaves the trader with a net profit of $5. The reverse is true for a put that falls within the $10 buffer of its strike. Should the stock surpass $10 past the strike price on either side, the strategy loses money.
“A short strangle can be a higher-risk strategy than a short straddle, but the chances of turning a profit are better,” BMO said.
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