I’m often asked about my favorite options strategy. What’s my bread and butter? Statistically speaking, it doesn’t get much better than the short strangle. Some say it is the ultimate options strategy.
A short strangle is a neutral, range-bound options strategy (short call and short put) that has undefined risk and limited profit potential. Typically, a short strangle has little to no directional bias. And, like most options selling strategies, short strangles benefit from a decline in implied volatility (IV) and passage of time (time decay).
Before I get to an example or two, I want to point out that short strangles require more capital. The reason is because we are selling naked options on both sides. But, don’t let that scare you.
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In return for the larger capital outlay, an options trader is rewarded with one of the highest probability options strategies in the investment universe. I’m talking an 85% probability of success. But hey, that’s one of the great things about selling options, using defined or undefined options strategies: you get to choose your probability of success on every trade you place.
But, there is one important caveat when trading short strangles.
Short strangles only work for the disciplined options trader. If you are not disciplined when it comes to risk management, naked options aren’t for you. I would suggest looking at iron condors. Iron condors are risk-defined.
That said, I would question why bother trading options or stocks if risk management isn’t your #1 priority, regardless of the strategy you choose. Just go to the casino. Use the numbers in front of you to make sound decisions. Allow the probabilities to lead the way…all you need to do is create a disciplined risk-management approach and the law of large numbers will take over. You will hear me say this repeatedly—all successful options traders have a rigid risk-management plan. Without it, failure is inevitable.
But I can’t emphasize enough: If you have the capital (taking position size into account) and look at yourself as a risk manager first and options trader second, well, this could be your new favorite strategy. There is a reason short strangles are the bread-and-butter options strategy for most professional options traders.
Let’s look at a few examples on how strangles work.
As I said before, strangles, like all options selling strategies, benefit from a decline in implied volatility (IV) and passage of time (time decay). So, the first step is finding a highly liquid stock or ETF that has a heightened level of implied volatility.
Look no further than the current IV rank and IV percentile of the stock.
IV rank tells us if the current level of volatility in a stock is higher comparable to the levels over the past year. Since we are selling options in the form of a short strangle, we prefer options prices to be inflated.
IV percentile tells us the percentage of days that implied volatility has traded below its current level of implied volatility over the past year.
Right now, Intel (INTC) fits the bill.
So, let’s take a look at a potential trade.
The stock is currently trading for 55.96.
The next item is to look at INTC’s expected move for the expiration cycle that I’m interested in.
The expected move or expected range over the next 29 days can be seen in the pale orange colored bar below. The expected move is from 51.50 to roughly 60.50, for a range of $9.00.
Knowing the expected range, I want to, in most cases, place the short call strike and short put strike of my short strangle outside of the expected range, in this case outside of 51.50 to 60.50.
This is my preference most of the time when using strangles. I want my short strangle to have a high probability of success.
If we look at the call side of INTC for August expiration, we can see that the 51 strike offers a 75.48% probability of success and the 50 strike offers us an 80.75% probability of success. And hey, I might even consider the 49 strike, with better than an 85% probability of success. All three are below the lower edge of INTC’s expected move, or 51.50.
Now it’s just a matter of what kind of return we are looking for on the trade. In this example, I’m going with the 50 put strike.
Now let us move to the call side. Same process as the put side. But now we want to find a suitable strike above the high side of our expected move, or 60.50. The 61, with an 85.60% probability of success, works.
We can create a trade with a nice probability of success if INTC stays between the our 11-point range, or the 61 call strike and the 50 put strike. Our probability of success on the trade is 85.60% on the upside and 80.75% on the downside.
I like those odds.
Here is the trade:
Simultaneously:
Sell to open INTC August 21, 2021 61 calls
Sell to open INTC August 21, 2021 50 puts for roughly $1.00
Our margin requirement is $751.74 per short strangle.
Again, the goal of selling the INTC short strangle is to have the underlying stock, in this case INTC, stay below the 61 call strike and above the 50 put strike through expiration in 29 days.
In most cases I would look to take the trade off when I can lock in 50% to 75% of the premium sold, or $0.25 to $0.50. Moreover, I will get out of the trade if it hits 1 to 2 times my original credit, or $2.00 to $3.00.
Here are the parameters for this trade:
- The Probability of Success – 85.60% (call side) and 80.75% (put side)
- The max return on the trade is the credit of $1.00, or 13.3%
- Break-even level: 49 – 62
- The maximum loss on the trade is in theory unlimited. Remember, we will adjust if necessary and always stick to our stop-loss guidelines. Position size, as always, is key.
Short strangles offer options traders one the highest probability strategies out there. And that’s why they are one of the strategies of choice amongst professional options traders. Undefined risks strategies can be scary for the uninitiated. But if you understand the risk of the strategy and are diligent with your risk management a whole new world of trading has just opened up.