THE OPTIONS COURSE- SHORT STRADDLE STRATEGY

THE OPTIONS COURSE


SHORT STRADDLE STRATEGY

A short straddle involves selling both a put and a call with identical strike prices and expiration months. This strategy is useful should the underlying futures remain fairly stable. It is attractive to the aggressive strategist who is interested in selling large amounts of time premium in hopes of collecting all or most of this premium as profit. In general, this is a neutral strategy with limited profit potential (the total credit from the short options) and unlimited risk. There is a significant probability of profit making but the risk can be very large, which is why I do not recommend placing a short straddle.

Short Straddle Mechanics

Let’s imagine you are selling a straddle on XYZ Corp. and shares are trading for $50 a share in December. The short March 50 call option is trading at $2.50 and the short March 50 put option is trading at $2.50. You forecast that XYZ is going to continue trading in a narrow range, which results in a decrease in volatility. Again, if you are expecting a decrease in volatility, you want to sell options. You want to sell high volatility and buy low volatility. Remember, XYZ is trading at $50 in this example. You have collected 5 points of net premium from the short options. The danger in this trade is that your maximum risk is unlimited to the upside and limited to the downside (as the underlying can only fall to zero). 

Remember, the safest trades have limited risk and unlimited reward potential or limited reward with a high probability of being correct. Although it’s unlikely, XYZ could go to zero, the call side has unlimited risk. Luckily, at expiration, only one side could be wrong. They cannot both be wrong. Anytime you sell an option, the net credit you receive is the maximum profit. Remember, when you sell options, you do not want market movement. You want the market to stabilize and go in a straight line. In this trade, you have collected $500. If XYZ stays between 55 and 45, you will make a profit. This is referred to as the profit range. 

When you sell straddles, it is vital to identify this range by calculating the upside and downside breakevens. This will enable you to determine the point at which the trouble starts. The upside breakeven occurs when the underlying asset’s price equals the option strike price plus the net premium. The downside breakeven occurs when the underlying asset’s price equals the option strike price minus the net premium. For example, the net premium for this trade is 5. Therefore, the upside breakeven is calculated by adding 5 to 50 to get 55. The downside breakeven is calculated by subtracting 5 from 50, which equals 45. Thus, your profit range exists between 55 and 45.

Since a long straddle has a V-shaped curve, a short straddle has an upside-down V-shaped curve because it is the combination of a short call and a short put. This shape clues us in to the fact that short straddles have limited profit potential and unlimited risk. If a market moves significantly from the centerline, you have unlimited potential to make profits when buying a straddle and unlimited risk when selling the straddle. Maximum profit is achieved if the market closes exactly at 50 by the expiration date. However, I do not recommend taking on this kind of risk. I include these examples so that you can understand the mechanics of this trade and be aware of the dangers inherent in shorting options.


FIGURE  Short Straddle Risk Graph

Exiting the Position

The following exit strategies can be applied for the short straddle example:

• XYZ falls below the downside breakeven (45): You will want to close out the put position for a loss due to the chance that the put will be assigned.
• XYZ falls within the downside (45) and upside (55) breakevens: This is the range of profitability. The maximum profit occurs when the underlying stock is equal to the strike price (50). Options expire worthless and you get to keep the credit.
• XYZ rises above the upside breakeven (55): You will want to close out the call position for a loss due to the chance that the call will be assigned.

Selling straddles is a risky trade unless you find markets that are not likely to move away from a centerline. However, there are methods that can be utilized to substantially reduce the risks associated with this strategy. For example, you may want to purchase a strangle against it, thereby creating a condor. However, due to the fact that a short straddle comes with unlimited risk, I do not recommend its use and primarily teach it for educational purposes only.

Short Straddle Case Study

A short straddle is a limited reward, unlimited risk strategy that profits if the underlying security trades sideways. Though profits can be made using this strategy, it is not one we at Optionetics suggest. Entering unlimited risk strategies is usually not a good idea and the short straddle is one of these. Since a long straddle requires a large move for the underlying security, it makes sense that a short straddle needs a sideways-moving, range-bound stock. However, because a short straddle consists of going short two options, the risk is high and the margin required to enter this strategy would be very large. Nonetheless, let’s look at a real-life example of how a short straddle works.

On December 1, 2003, Home Depot (HD) was trading just under $37 a share. At this time, a trader might have believed the stock was set to trade sideways until late January when retail sales data for the month would be tabulated. As a result, a short straddle could be entered. A short straddle profits as long as the stock closes at expiration near the strike used. Since this strategy benefits from time decay, short-term options are typically used. In the case of HD, January 2004 options were used. However, because HD is in between strikes, the trader needs to decide whether the stock will move slightly higher or slightly lower by expiration. Let’s use the 37.50 strike for this example.

The January 37.50 calls can be sold for 0.85 and the January 37.50 puts can be sold for 1.60. If five contracts were entered, the total credit would be $2.45 per contract or $1,225, with unlimited risk. The breakeven points are found by taking the credit of $2.45 per contract and subtracting it from the strike price for the lower breakeven and adding it for the higher breakeven. Thus, our breakeven points are at 35.05 and 39.95. If HD were to close in between these points at expiration in January, a profit would be made. The profit zone is a very small portion of the graph, with the loss section quite large. 

This type of risk profile normally means a large amount of margin will be needed, and this is definitely the case with a short straddle. Home Depot did in fact trade sideways until January expiration, but the move was slightly to the downside, with the stock closing at $34.96. As a result, this trade would have lost about $55. If the 35 strike had been used, nearly the maximum profit would have been achieved. This is the major difference between straddles and strangles. A strangle has a wider trading range, but brings in a smaller credit. A straddle has a larger credit, but a much smaller profit zone.


FIGURE  Risk Graph of Short Straddle on HD 

LONG STRANGLE STRATEGY

Strangles are quite similar to straddles, except they use OTM options, which changes the dynamics of the trade entirely. To construct a long strangle, you want to buy both an OTM call and an OTM put with the same expiration month but different strike prices. The best time frame to use for this options strategy is at least 60 days. Since the maximum risk is limited to the double premium for the long options, a strangle should be viewed with respect to how expensive the options are. More often than not, one side will be underpriced and the other side will be overpriced.

The strike prices of the options used are the main difference between a straddle and a strangle strategy. A strangle has strikes that are slightly out-of-the-money, while straddles use ATM options. For example, if XYZ was trading at about $97, then the XYZ 100 calls and the XYZ 95 puts could be purchased to create a long strangle. The advantage of this strategy is that the potential loss—should XYZ remain at $97 at expiration—is less than that of a straddle. The disadvantage is that the stock needs to move even further than a straddle for the position to become profitable. Despite the fact that the strangle might look much cheaper than the straddle, it also carries more risk.

Long Strangle Mechanics

Let’s create an example with XYZ priced once again at $50 per share. Let’s select a strangle by going long a September 55 call for $2.50 and a September 45 put for $2.50 (see Figure 8.8). Once again, although you have no margin requirement, you are still going to have to pay both premiums. However, you are going to pay less than if you bought a straddle, because a strangle uses OTM options. Unfortunately, even though they cost less, you will need the market to make even greater moves to ever get your money out. This trade is delta neutral because the OTM options combine to create an overall position delta of zero (OTM call = +30; OTM put = –30). The maximum risk on this trade is the cost of the double premiums, which equals $500: ($2.50 + $2.50) × 100 = $500. 

Your maximum profit is unlimited. As shown by the long strangle’s U-shaped risk curve, this strategy has unlimited profit potential and limited risk. The upside breakeven occurs when the underlying asset equals the call strike price plus the net debit paid.  In this case, the upside breakeven equals 60: (55 + 5 = 60). The downside breakeven occurs when the underlying asset equals the put strike price minus the net debit. The downside breakeven equals 40: (45 – 5 = 40). The profit zones are therefore above 60 and below 40. Unfortunately, profit depends on a large move in the underlying instruments. A market with extremely high volatility might give you the necessary kick to harvest a profit from a long strangle strategy.


FIGURE  Long Strangle Risk Graph

Exiting the Position

The following list provides some practical guidelines for exiting a strangle:

• XYZ falls below the downside breakeven (40): You can close the put position for a profit. You can hold the worthless call for a possible stock reversal.

• XYZ falls within the downside (40) and upside (60) breakevensThis is the range of risk and will cause you to close out the position at a loss. The maximum risk is the double premiums paid out of $500.

• XYZ rises above the upside breakeven (60): You are in your profit zone again and can close the call position for a profit. You can hold the worthless put for a possible stock reversal.

Long Strangle Case Study

A long strangle is the simultaneous purchase of a call and a put using different strikes, but the same expiration month. Since it involves the use of a long call and a long put, the cost to enter is high, but less than when using a straddle. This is because we are buying a call that is slightly out-of-the-money as well as a put that is slightly out-of-the-money. As with a straddle, a long strangle should be used on options that have low implied volatility. When a stock has been trading in a range and a break is expected, a long strangle is one way to profit without predicting the direction of the move. In order to see how this works, let’s look at a real-life example. At the end of 2003, shares of Cisco (CSCO) started to consolidate once again and this led to the belief that a breakout would soon occur. 

On December 26, CSCO shares closed at $23.75. The idea was that if the stock broke 25 to the upside or 22.50 to the downside, a major move would occur. So, a strangle using the April 25 call and the April 22.50 put was entered. The April 25 calls cost $1.05, as did the April 22.50 puts. Buying five contracts would cost $1,050, which was also the maximum risk of this multiple-contract position. The nice thing about a strangle, as with a straddle, is that if the stock doesn’t move as expected, the straddle owner can get out without much of a loss as long as he or she will not hold onto the options until expiration. This is because time decay is light when an option is still several months away from expiration.

This is because the maximum loss occurs if the underlying closes within the strikes at expiration. The breakevens for this trade are found by adding the debit per contract of 2.10 to the strike of 25, which is $27.10 to the upside. The downside is found by subtracting 2.10 from the strike of 22.50, or 20.40. Cisco did break out of this consolidation and did so to the upside. Once the $25 mark was passed, the gains came fast. The stock reached its peak on January 20 at $29.39, but the bearish pattern on January 21 would have taken us out of the strangle. At that point, Cisco was trading at $28.60 and the total profit for the strangle was $1,075—a 102 percent return on investment.


FIGURE  Risk Graph of Long Strangle on CSCO

SHORT STRANGLE STRATEGY

A short strangle is simply the opposite of a long strangle—you sell an OTM call and an OTM put with different strike prices and the identical expiration month. A short strangle has an upside-down U-shaped risk curve, which tells us that it has limited profit potential and unlimited risk. In fact, your potential profits are less than when you place a short straddle because OTM premiums cost less than ATM premiums and deliver a reduced overall credit to the seller. 


FIGURE  Short Strangle Risk Graph

However, your risk is also a little less than with the straddle because the market has to make a bigger move against you to reach the limits of your profit range. In most cases, you will have a margin requirement on this kind of trade. Short strangles are market neutral strategies as are short straddles. If the market doesn’t move, you get to keep the premium. If you were expecting a huge move, with lots of volatility, would you sell a straddle or a strangle? Neither, not unless you have a death wish. Increasing volatility is a signal for long straddles and strangles.

Short Strangle Example

Using XYZ trading at $50 a share in February, let’s create an example by selling one March 55 call at 2.50 and selling one March 45 put at 2.50. This is a classic example of selling a strangle. Your maximum reward is the net credit of the option premiums or $5, which equals $500 a contract: (2.50 + 2.50) × 100 = $500. The maximum risk is unlimited. The upside breakeven occurs when the underlying asset equals the call strike price plus the net credit. The upside breakeven for this trade is 60: (55 + 5 = 60). The downside breakeven occurs when the underlying asset equals the put strike price minus the net credit, which is 40: (45 – 5 = 40) in this trade. Therefore the profit range is between 40 and 60.

Exiting the Position

Let’s take a look at possible exit strategies for the short strangle example:

• XYZ falls below the lower breakeven (40): You will want to close out the position for the loss since the put is ITM and in danger of assignment.
• XYZ falls within the lower (40) and higher (60) breakevensThis is the range of profitability. Both options expire worthless and you get to keep the double premiums or maximum profit of $500 (minus commissions).
• XYZ rises above the higher breakeven (60): You will want to close out the position since the call is ITM and in danger of assignment.

The short strangle strategy is best used in combinations of spreads and butterflies and other option strategies. They can be added to these types of trades for extra protection. Once again, we do not recommend selling a strangle due to the unlimited risk that comes with it; however, it is essential to understand how they work so that you can integrate them into other trades.

Short Strangle Case Study

A short strangle is a limited reward, unlimited risk strategy that profits if the underlying security trades sideways. Though profits can be made using this strategy, it is not one I usually recommend. I’ll say it again: Entering unlimited risk strategies is rarely a good idea! However, it’s important to understand how the short strangle strategy works. A long strangle requires a large move for the underlying security, so it makes sense that a short strangle needs a sideways-moving, range-bound stock. However, because we are short two options, the risk is high and the margin required to enter this strategy would be very large. 

Nonetheless, let’s look at a real-life example of how a short strangle works. On December 10, 2003, shares of the Nasdaq 100 Trust (QQQ) were trading at $34.56 each. At this time, a trader might have believed the stock was set to trade sideways during the holidays, as the chart had been moving side-ways for several months. As a result, a short strangle could be entered. A short strangle profits as long as the stock closes at expiration in between the two strikes. Because this strategy benefits from time decay, usually short-term options are used. In the case of QQQ, January 2004 options were used.

The January 36 calls could be sold for 0.50 and the January 33 puts could be sold for 0.55. If five contracts were entered, the total credit of the option premiums would be $1.05, or $525 for the five contracts, with unlimited risk. The downside breakeven is calculated by subtracting the credit of $1.05 per contract from the lower strike price. The upside breakeven is calculated by adding the credit to the higher strike. In this example, the breakeven points are at 31.95 and 37.05. If the Qs were to close in between these points at expiration in January, a profit would be made.


FIGURE  Risk Graph of Short Strangle on QQQ

The profit zone is a very small portion of the graph, with the loss section much larger. This type of risk profile normally means a large amount of margin will be needed, and this is definitely the case with a short strangle. In this case, the Qs did not stay in their range, as they broke out to new highs in early January. However, a smart trader probably would have looked to get out on December 29 when the Qs broke above resistance at 36. At this point, the risk would have been minimal, but if the holder of this short strangle were to hold on until expiration, a large loss would have occurred.

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