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Short Strangle

 

Description

 

The Short Strangle is a simple adjustment to the Short Straddle to improve the probability of a profitable trade by widening the strikes and therefore the break even points. Instead of selling at-the-money options, you sell out-of-the-money calls and puts, which means a lower net credit but typically wider break even points.

         

The Short Strangle is precisely the opposite of a (Long) Strangle. We short out-of-the-money puts and calls with a short time to expiration (one month or less) in order to pick up income. Because you are short options, time decay works for you, so you only select short-term expiration dates.

 

Also you are exposed to potentially unlimited risk, which is another reason for making this a short-term strategy. Its worth reemphasizing that the problem is that

you could be successful at it for months, picking up modest income over and over

again, and then all at once one big loss will wipe out years worth of gains.

 

Each leg of the trade has uncapped downside. If the stock starts going ballistic in

either direction, then your position is precarious to say the least. If the stock remains rangebound, then you will make a limited profit. If the stock gaps in either direction, you are history!

 

Note: you would never trade this strategy right before a news event like an earnings report. You certainly would not want any nasty surprises to be lurking around the corner.  

 

Market Opinion

 

Directional neutral.

 

P/L

 

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When To Use

 

Use this strategy when you anticipate no movement in the stock and are looking for income.

 

Example

 

XXXX is trading at $25.37 on May 14, 2011.

Sell June 2011 $22.50 strike put for $0.35.

Sell June 2011 $27.50 strike call for $0.65.

 

Net credit: premiums sold = $1.00.

 

Benefit

 

The benefit of this strategy is the possibility of receiving a high yield income on a rangebound stock.

 

Risk vs. Reward

 

The risk is unlimited. The reward is limited to the net credit you receive from selling puts and calls.

 

Net Upside

 

Net credit received.

 

Net Downside

 

Uncapped.

 

Break Even Point

 

Break even up: net credit received.

 

Break even down: lower strike minus net credit.

 

Effect Of Volatility

 

Negative when your position is profitable, and positive when it is not profitable.

 

Effect Of Time Decay

 

Positive. You are in short options, so you want to be out of them as soon as possible.

 

Alternatives Before Expiration

 

To stem a loss, buy back the option if the stock breaks through resistance or support.

 

Or buy back both options if you are in profit, but you think news could change market opinion about the stock.

 

Alternatives After Expiration

 

Close out the position by buying back your calls and puts.

 
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