Order Entry: Net Credit
Ideal Environment: High IV
Profit Target: 50%
Definition: A strangle consists of simultaneously selling an OTM call and put at the same time. The trade results in net credit and is an overall neutral position. Strangles have undefined risk, so the max loss is unknown entering the trade. The strategy makes money when the underlying asset has little movement in price over the duration of the options and volatility contracts.
Sell 1 OTM Call
Sell 1 OTM Put
The max profit for a strangle is the net credit received when the trade is put on. The best case scenario is that the underlying asset price is unchanged over the duration of the options and the price settles at the strikes sold when entering the trade.
Max Profit= Net Premium Received - Commissions Paid
To calculate the breakeven stock price for the trade, use the following formulas:
Downside = Put Strike - Credit Received
Upside = Call Strike + Credit Received
Unlimited (Undefined) Risk
Strangles involve selling naked options. If the stock price has a large swing up/down, strangles lose money. The hope is that the theta decay outweighs the loss with the directional move of the underlying stock. Best case scenario is if the options settle in the middle of both OTM strikes. When the underlying asset rises above the OTM call (the loss is determined by the value of the call minus the initial credit received). When the underlying asset falls below the OTM put (the loss is determined by the value of the put minus the initial credit received).
Max Loss = Unlimited
Suppose stock ABC is trading at $40 in January. An options trader is neutral on ABC decides to enter a strangle position by selling an OTM $42 call and OTM $38 put. Both options have a DTE of 45. The trade results in a credit of $135.
The price of ABC stock over the period of the trade ends up at $39. Both The call and put are worthless. The trade results in a $135 profit (max profit) minus commissions.
If the price settled at $43, the call would have been ITM by $100 and the put is worthless. In this scenario, the trade results in $35 profit minus commissions.
If the stock had fallen to $33 at the end of expiration, the trade would have resulted in a loss of $365. The put has intrinsic value of $500 and the call is worthless. The trader only received a $135 credit at the beginning of the trade. The same thing happens if the stock rose to $47. Except in this scenario, the call has an intrinsic value of $500. Remember that with short strangles comes unlimited risk, therefore there is no max loss.
When to use a strangle strategy?
At Tradezy, we recommend to use this strategy for stocks with a high implied volatility. The trader should have a short to intermediate neutral thesis. Since the trade has undefined risk, we don’t necessarily have a target amount of premium we want to collect. The large the credit received though allows are breakeven points to expand. The credit received is not only determined by IV, but the price of the underlying asset as well (higher the strike prices = higher the credit) In terms of duration, we look to sell a position that has around 45 DTE. The goal is to buy back the spreads at 50% of max profit.