The short strangle is an options trading strategy used when an investor expects the price of an underlying asset to remain relatively stable or move within a specific range. It involves selling a call option with a higher strike price and selling a put option with a lower strike price simultaneously. Let’s break down this strategy in simple terms:
1. How the Short Strangle Works:
- To implement a short strangle, the investor sells both a call option and a put option on the same underlying asset.
- The investor receives a premium (payment) for selling each option contract.
- The call option’s strike price is set higher than the current market price of the asset, while the put option’s strike price is set lower than the current market price.
2. Expectation and Profit Potential:
- The short strangle strategy is used when the investor expects the underlying asset’s price to remain relatively stable or move within a specific range during the options’ lifespan.
- The investor profits from the premium received from selling the call and put options if the asset’s price stays between the two strike prices.
- The strategy’s profit potential is limited to the premiums received, which is the maximum profit achievable.
3. Risk and Loss Potential:
- The short strangle strategy carries the risk of unlimited losses if the asset’s price moves significantly beyond the strike prices in either direction.
- If the asset’s price rises significantly above the call option’s strike price or falls significantly below the put option’s strike price, the losses can be substantial.
- The losses are not limited, as there is no cap on how far the asset’s price can move.
4. When to Use the Short Strangle:
- Traders use the short strangle when they believe that the underlying asset’s price will not experience large movements or volatility during the options’ lifespan.
- It is a neutral strategy that benefits from a decrease in the asset’s price volatility.
Example of Short Strangle:
Let’s assume an investor believes that Company XYZ’s stock, currently trading at $50, will not experience significant price swings over the next month. They decide to implement a short strangle strategy by selling the following options:
- Sell a Call Option: Strike price $55
- Sell a Put Option: Strike price $45
For each option contract sold, the investor receives a premium of $2. If both options are sold, the total premium received is $4 (2 call options x $2 premium + 2 put options x $2 premium).
Scenario 1: Price Remains within Range
- If, at the options’ expiration, Company XYZ’s stock price remains between $45 and $55, both options will expire worthless, and the investor keeps the entire $4 premium as profit.
Scenario 2: Price Moves Beyond Range
- If the stock price moves above $55 or falls below $45 significantly, the investor may face losses. The losses are potentially unlimited as the stock price moves further away from the strike prices.
It’s essential for investors to carefully assess their risk tolerance and market expectations before implementing the short strangle strategy. Risk management and monitoring the trade are crucial to manage potential losses effectively.