An option short strangle is an option strategy where a trader will simultaneously short (sell) an out of the money call and an out of the money put on the same commodity with the same expiration month. A commodity trader might want to use this strategy if he or she expects a market to stay in a fairly narrow trading range until the options reach expiration. Thus a trader would profit as both of the options drop to a price of 0.
For example, if June gold futures were trading at $1,163, a trader could sell a $1,200 June gold call at 13.60 and collect $1,360 in premium. He could also sell a $1,125 put option for 12.60 and collect $1,260 (before commissions). The trader would collect a total of $2,620 in option premium before commissions and he would also have to put up some futures margin to secure the position.
When to use the Short Strangle Option Strategy
The optimal time to use the short strangle strategy is right at the end of a highly volatile period of trading that moves into a period of low volatility. In other words, if the market is making a strong move higher or lower or even making wild swings in both directions and you expect the market to calm down and trade in more narrow range - that is when the option strangle works best.
When markets make big moves, it means there are more opportunities to make large profits buying options, so traders will bid up the prices of options. Oppositely, when a market is stuck in a narrow range, option premiums tend to decrease as traders see less opportunity for profits as time is running out on the options. Remember, a trader makes money when the options drop in value as he sold the options first and then buys them back later or lets the options expire at a value of $0.
Benefits and Risks of the Short Strangle
One of the major benefits of the short strangle is the trader has time on his side. Options will theoretically lose value everyday as time decays on the options. Options are being sold short with this strategy, so the traders wants to see the options expire worthless. The trader also has the luxury to close the positions at any time before the options expire to realize a profit or loss.
A second benefit is the trader can make money on both options or at least one of the options will make money if the underlying market keeps moving in one direction. The profit on one side of the trade will help offset the loss on the other side.
The risk on the trade is theoretically unlimited for either the call or put options. If the market makes a sharp move in either direction, this trade will likely lose money. The losses can be substantial if the trader doesn't cut his losses in a quick manner.
Overall, the option short strangle can be a higher probability option strategy. The wins on the trade can only be 100 percent minus commissions and fees. Therefore, a trader cannot afford to let losses of more than 100 percent to occur regularly and make this a good long-term options trading strategy.
This strategy if often considered the opposite of the option straddle.
