A short strangle gives you the obligation to buy the stock at strike price A and the obligation to sell the stock at strike price B if the options are assigned. You are predicting the stock price will remain somewhere between strike A and strike B, and the options you sell will expire worthless.
By selling two options, you significantly increase the income you would have achieved from selling a put or a call alone. But that comes at a cost. You have unlimited risk on the upside and substantial downside risk. To avoid being exposed to such risk, you may wish to consider using an iron condor instead.
Like the short straddle, advanced traders might run this strategy to take advantage of a possible decrease in implied volatility. If implied volatility is abnormally high for no apparent reason, the call and put may be overvalued. After the sale, the idea is to wait for volatility to drop and close the position at a profit.
NOTE: Both options have the same expiration month.
Who Should Run It
NOTE: This strategy is only for the most advanced traders who like to live dangerously (and watch their accounts constantly).
When to Run It
You are anticipating minimal movement on the stock.
Break-even at Expiration
There are two break-even points:
The Sweet Spot
You want the stock at or between strikes A and B at expiration, so the options expire worthless.
Maximum Potential Profit
Potential profit is limited to the net credit received.
Maximum Potential Loss
If the stock goes up, your losses could be theoretically unlimited.
If the stock goes down, your losses may be substantial but limited to strike A minus the net credit received.
TradeKing Margin Requirement
NOTE: The net credit received from establishing the short strangle may be applied to the initial margin requirement.
After this position is established, an ongoing maintenance margin requirement may apply. That means depending on how the underlying performs, an increase (or decrease) in the required margin is possible. Keep in mind this requirement is subject to change and is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.
As Time Goes By
For this strategy, time decay is your best friend. It works doubly in your favor, eroding the price of both options you sold. That means if you choose to close your position prior to expiration, it will be less expensive to buy it back.
After the strategy is established, you really want implied volatility to decrease. An increase in implied volatility is dangerous because it works doubly against you by increasing the price of both options you sold. That means if you wish to close your position prior to expiration, it will be more expensive to buy back those options.
An increase in implied volatility also suggests an increased possibility of a price swing, whereas you want the stock price to remain stable between strike A and strike B.
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