Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2023-07-20T18:06:31+05:30
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Introduction

A short strangle is made up of one short call option with a higher strike price and one short put option with a lower strike price. Both options have the same underlying stock and expiration date, but their strike prices are different. If the underlying stock trades in a small range between the break-even points, a short strangle is formed for a net credit (or net receipt) and profits. Profitability is restricted to the total premiums received minus commissions. If the stock price rises, the potential loss is unlimited; if the stock price falls, the potential loss is large. Browse through this article to become familiar with this trading strategy.

What is the Short Strangle Strategy?

So, what is short strangle? A short strangle strategy is neutral and enables an investor to get advantages from the status quo in a financial market. The short strangle strategy deals with options selling. Therefore, it is called the sell strangle. 

The sell strangle option will be suitable for situations when an options trader thinks that the market will witness little to no volatility in the upcoming days. With the short strangle, the trader relies on the possibility that the value of the underlying assets will stay between the two short strike prices with the passing of time. 
 

How Does the Short Strangle Strategy Work?

Now that you know what is short strategy, let’s explain how it works. The short strangle option comes with limited profit potential. Traders can gain maximum profit from a short strangle strategy when on the expiration date, the value of the underlying asset remains between the strike prices of the strangle. In that case, the highest profit of the investor can be calculated by checking the difference between the net premium and the commissions.

Types of Strangles

●    Long Strangle: The long strangle option strategy is pretty popular and revolves around buying an out-of-the-money put option and an out-of-the-money call at the same time. The strike price of the call option remains greater than the present market price of the underlying asset. But the strike price of the put option remains lower. The risk associated with this strategy is the difference between the premiums of the two options. 

●    Short Strangle: A short strangle strategy revolves around selling an out-of-the-money call and out-of-the-money put at the same time. Even though the technique has low-profit potential, it is pretty safe. A short strangle makes money when the prices of the underlying stocks trade in a short range between the breakeven points. The maximum gains from a short strangle are the same as the difference between the net premiums collected for writing the trading fees and two options. 
 

Components of a Short Strangle

A typical short strangle option strategy example will include the following components:
●    Overview: The short strangle can primarily succeed when the volatility and stock price remain stable during the entire life of the options. 
●    Variations: While discussing the variations, it’s worthwhile to discuss the short strangle vs straddle option strategy. The strangle will vary from a straddle when the call strike is greater than the put strike. Usually, both the put and the call are out of the money and closer to central from the underlying stock when it has begun. 
●    Profit and Loss: The maximum loss and gain associated with the short strangle unlimited. The maximum loss comes when the stock reaches infinity. When the stock becomes worthless, the loss can be pretty significant. In the case of both, the loss gets reduced according to the premium amount received from selling the options. On the contrary, the maximum gain is associated with a stock value between the strike prices. In such cases, both options expire without any worth. Therefore, the investor gets to keep the premium received by selling the option.  
●    Breakeven: The short strangle option strategy will break even when the price of the stock is more than the call price strike or less than the put price strike in relation to the premium amount received at the date of expiration. In the case of at least one level, the intrinsic value of one option will be the same as the premium received for selling both options. Meanwhile, the other option becomes worthless while expiring. 
●    Time Decay: The passage of time usually has a positive impact on the short strangle strategy. Every day passes off without any movement in the stock prices. It makes both options one day closer to expiration. 
    Volatility: When there’s an increased risk in the implied volatility, a negative impact occurs on the short strangle strategy. Even when the stock price remains stable, an instant rise in implied volatility will pull up the value of both options. As a result, the investor will be forced to pay the additional margin to look after the position. 
    Assignment Risk: Early assignment usually takes place for a call only when the stock reaches ex-dividend. In the case of the put, it goes deep in the money. 
 

A typical short strangle option strategy example will include the following components: ● Overview: The short strangle can primarily succeed when the volatility and stock price remain stable during the entire life of the options. ● Variations: While disc

The short strangle option strategy comes with unlimited risk potential. All options investors should remember the following tips while putting forward the position:
●    The short-strangle ideal is when the market predictions are almost neutral, and only limited market action can take place. In the market, there are often large announcements and events that can trigger massive changes in prices. The interim period between such events is the best for implementing this strategy. 
●    At times, the trader considers the options to be overvalued while the predicted volatility is pretty high. The short strangle option adjustment strategy is perfect in such a scenario. It comes with an opportunity for the investor to earn profits from the price corrections. 
●    Investors can leverage the time decay while using this strategy. The investor needs to keep the time period to the expiration date as short as they can. The maximum time period should be one month if the investors intend to take advantage of the time decay. 
 

Conclusion

The best short strangle option strategy is the perfect choice for investors when they intend to leverage the low-volatility periods in the market. However, choosing the strike prices and assets wisely is crucial for the short strangle option strategy to work, particularly during massive-price fluctuating events or announcements. But like all other strategies, investors should consider their own discretion to receive the best outcome while implementing this strategy.  

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