The short strangle strategy is the opposite of the long strangle. It consists of the simultaneous writing of the same number of OTM calls and puts, with different strike prices but the same expiration, on the same underline security. It is similar to the short straddle strategy but with different strikes.
When to use
When we believe that the price of the underline security will remain relatively stable or within a price range and the implied volatility is also high. The higher the implied volatility the more money we earn from the short selling of the premiums and if the stock at expiration is anywhere inside the range which is defined from the two different strikes, then all options will expire worthless and we will accomplish the maximum profit.
On the other hand, a strong price move in either direction above the higher or below the lower strike, which exceeds the aggregate premium we have received, can cause us great loss. For example, if the premium received is $3/share and the stock moves $5 beyond any strike, then we will have a loss of $2/share, which is $200 if we have written one call and one put ($2×100). The strategy has almost unlimited losses in both directions and that’ s why it is considered risky.
Loss/Profit at expiration
Maximum loss: Unlimited to the upside and until the stock goes to zero to the downside (put strike – 0) – premium received + commissions.
Maximum profit: Premium received – commissions.
Below we can see the profit/loss diagram for the short strangle strategy. We have written one call with premium $2 and strike $25 and one put with premium $1 and strike $20.
Short strangle strategy example
In the daily chart of stock DE (below), we have spotted a strong resistance (line 2) and a strong support (line 1). Also, after a sharp downward move implied volatility is above the average. We believe that within a month period price will not exceed the support line at $70 or the resistance line at $84.
In that case we can write one call with strike $82.50 and premium $1 and one put with strike $70, premium $0.80 and expiration for both of them after one month. The aggregate premium we receive is $180 [($1+$0.80)x100]. If the stock at expiration is within the range defined by the strikes, then the options expire worthless and we accomplish the maximum profit which is $180 minus commissions.
If the stock at expiration is $1.80 above the higher strike or below the lower strike then we are break-even (without estimating commissions), but above $1.80 we are having losses.