Risk Profile: Undefined
Number of Legs: 2
Level of Complexity: ⅖
Buying Power Needed: 4/5
Net Short or Long Premium?: Short
The short strangle is a market neutral options trading strategy that consists of two out of the money options: a short call, and a short put. The strategy is best used in lower volatility markets, because we don’t want the price of the stock to move. An ideal setup for a short strangle is within an instrument that has been relatively inactive and trading within a range.
The implied volatility environment is quite important to the successful implementation of this strategy. While we want to find setups with low implied volatility, we also want implied volatility to be on the downtrend. If IV is low, but headed upwards, this is a setup we want to avoid. Conversely, when IV is low, but headed downwards, that is our ideal situation for a short strangle.
The risk of this strategy is undefined due to the fact that we’re shorting two contracts with no hedge. On the other hand, our max profit is limited to the credit we receive when we open the trade.
Many traders shy away from such reward/risk ratios, as you can potentially book a huge loss, and your profit potential is very limited. This reward/risk is skewed because we have such a high probability of success on this trade.
When poorly managed, one can be “picking up pennies in front of a steamroller.” The short strangle is the highest risk strategy of the three within this guide. One loss can offset months of wins without proper risk management.
We don’t create options spreads for the sake of sophistication. We do it because the many strike prices and expiration dates available in the options markets allow us to express various market views that we otherwise couldn’t with simpler instruments like equities.
With that said, each different options strategy has an underlying goal. We just talked about the vertical spread. There are many options traders who explain to you exactly what a vertical spread is, how the payoff works, and all of the math behind it. But, if you were to ask them to explain the merits of using a vertical spread as opposed to a diagonal spread, they will look like a deer in the headlights.
We want to trade strangles when volatility is low and price is likely to stay within a relatively tight range. We’re going to look at two strangle setups, a more ‘standard’ setup of a stock we think will trade in a range for the next 30-60 days, than we are going to look at a pre-earnings strangle.
Standard Strangle Setup
We’re going to look at the Unilever stock, which has been trading in a pretty tight range for all of 2018. Here’s a chart that outlines it’s range.
Now, we have to find an expiration in the Unilever options chain that offers favorable risk/reward while still staying true to the range we believe the stock will stay within. For a standard short strangle setup, we find the most favorable risk/reward to be in the 30-60 DTE dates. We are left with two expirations: December 21, 2018, which is 32 DTE and January 18, 2018, which is 60 DTE.
Here are the two options tables. As you can see there is almost no volume done in the Jan 18 strikes, so we are left with Dec 21.
In choosing our strikes, we have to keep in mind that the wider we make our spread, the less our max profit becomes. We want to find the happy medium between giving the stock room to breath and trade at various prices, and keeping the spread tight to maximize profit. Trading short strangles is an art, not a science, so figuring out the right strikes to choose will take a combination of experience and knowledge, as there is no ‘golden rule’.
Unilever has a limited choice of options contracts compared to the blue chip stocks many of us are used to, so we have a bit less leeway in choosing strike prices.
On the upper end of our spread, the $57.50 strike would be too tight, as it is too far inside of UN’s trading range.
The next closest strike of $60 is just about our only choice in this instance. Luckily, it is not too far outside our desired range and gives us some safety to the upside.
On the lower end of our spread, we have the choice of two strikes: $50 and $52.50. While $52.50 is more liquid, it is sitting right at the bottom of UN’s trading range, an area that UN just recently traded around. While $52.50 would be a more profitable choice, I think it’s just a bit too close and I elected to choose $50.00.
These are the two strikes we’ve decided on for our UN trade.
Max Profit & Loss
Here is a payoff matrix for our UN trade:
We reach max profit when the price of the underlying remains between both of our strikes, or within our ‘range’. When this happens, both of our options expire worthless, or out-of-the-money. This is because we wrote these options, so we get to keep all the premium paid to us by the buyers of these options. Our max profit is equal to our net credit.
To figure out what our net credit is, simply add together the prices you’ve paid for both of your options. In this case, it’s $0.15 + $0.15 = $0.30 in credit.
Our maximum loss in this strategy is uncapped, and will continue until you close the trade, as you can see in our payoff matrix above.
Best Buy is reporting their Q3 2018 earnings on November 20th, 2018, so we’re looking at the nearest expiration, which is November 23rd, 2018. As you can see, there’s a great deal of premium built into these options, approximately 5%, which is an annualized rate of 271%.
Generally, implied volatility is mean reverting, and the price moves it implies are often overstated. This is why most successful options traders seem to be biased towards shorting premium, rather than buying it. This phenomenon is why the short strangle is a great strategy to trade during earnings season, because markets tend to overestimate the price moves post-earnings.
The trickiest part about trading a short strangle within a high implied volatility instrument like Best Buy, especially before earnings, is choosing the strike prices. The wider your spread is, the less your max profit is, and vice versa.
While the high profit potential of tight spreads might look attractive, you have to ask yourself: how likely is it that the stock will stay within this tight range? While there’s lots of variance across short strangle setups, a good general width is one standard deviation from the current underlying price.
That said, if you’re ready to execute this strategy, you should have a good idea of how wide of a spread you want to trade. If you don’t I suggest you stick to iron condors and vertical spreads until you’re more seasoned.
Here’s what a short strangle payoff looks like:
We’re going to continue with the Best Buy example, which I consider to be a bread-and-butter setup for a short strangle earnings play. Here’s why:
- Very high implied volatility (expensive premium)
- Stock has been range-bound for the better part of a year
Here’s what one standard-deviation wide short strangle looks like. Because of BBY’s high implied volatility, our spread is 19 points wide, or about 28% of the current underlying price. This means that the stock can move 14% on either side before our trade is in the red.
Again, we’re not here to show you cherry-picked trade examples to convince you to trade options, not even close. The goal here is to teach you how to use these options strategies to think for yourself. That’s why we’re going to look at some catalysts facing Best Buy as a company that would indicate that it’s a good candidate for a pre-earnings short strangle trade.
The confluence of these factors would indicate, to us, that the implied volatility in Best Buy is overestimating the market’s response to their earnings report.
- The firm has reported consistent, but not amazing growth
- The firm reported same-store sales growth of 8% in their Q1 fiscal year 2019 earnings report.
- The widespread belief among investors that the retail sector is a melting ice cube contracts retail valuations, setting a theoretical cap on how much the stock can be bid up, even in the face of a huge earnings beat.
- The company has a healthy cash position on it’s balance sheet, and generates positive free-cash-flow.
- Despite the increasingly difficult environment for retail chains, Best Buy has thrived, partly feeding off of their competition’s failures.
- The current valuation seems hinged upon the firm continuing to grow fast, but there’s some evidence that growth may be slowing
- The company is guiding for slowing same-store sales growth of 2.5% – 3.5% for Q3 2019, which would be the slowest in six quarters.
Max Profit and Loss
Here is a payoff matrix of our short strangle on Best Buy:
Our max profit in a short strangle is our net premium received. In the case of our BBY trade, our net premium received is $1.23 x 100 = $123.
To calculate your net premium received in a short strangle trade, simply add the prices of your two contacts together. In our BBY trade, our short put is $0.675 and our short call is $0.615, the sum of which is $1.23.
We achieve max profit when the price of the underlying is between our two strikes at expiration, making our options expire worthless, allowing us to collect the full premium.
We have no maximum loss in this strategy, as we’re selling two naked options. If price goes against one of our contracts, there is no level where we stop losing money, we must close the trade to cap our losses.