Best Short Strangle Adjustments: 3 Short Strangles

hey everyone welcome back to the show my name is Mike this is my whiteboard and today we're going to be talking about our mini-series on adjustment again we're going to actually look into strangles today so we're going to look at the opening trade we're going to look at some things that can happen throughout the trade maybe an increase in implied volatility or maybe a decrease in the stock price or maybe both and we're going to we're going to analyze what we can do to move our breakevens to our benefit and also give us a better chance to be successful in the long run so let's look at the first opening trade and just to recap what a strangle is it's really just selling two out of the money options specifically and out of the money put and an out of the money call together at the same time in the same expiration cycle so what this does is it creates a profit zone between these short strikes because if I have a short put that is a bullish assumption and I sell a short call which is a bearish assumption both of these assumptions are going to battle each other but it creates a profit zone within the strikes so anywhere between these strikes 70 and 90 as long as the stock price expires there then at expiration these options are going to stay out of the money they're not going to have any intrinsic value at all and they would expire from my account they would disappear and I would be able to keep that credit I originally received when we're looking at this trade specifically I've got a dollar fifty credit let's say and let's say that I'm looking at an expiration of a perfect 45 days to expiration you'll hear that often on tastytrade that we're looking for that 40 to 45 days to expiration window and that's because that is the time frame that give us gives us the best P&L per day when we're selling premium so that's why we always go to that 45 40 to 45 day till expiration mark so let's say I've got this perfect setup where I'm collecting a dollar 50 credit I've got 45 days to go which means if I'm collecting a dollar 50 credit my max profit on this trade is going to be 150 dollars again when we're talking about option contracts if I'm selling a one lot which means I'm just selling one put and one call to create this strategy if I'm selling a one lot I have to multiply my credit of $1 50 by 100 because one option contract has a theoretical equivalent or theoretical control of 100 shares of stock so I always need to take that dollar 50 value and multiply it by 100 to see what my max profit would really be in real world terms since I'm selling a short call my max loss is considered to be unlimited of course a stock can only go to zero it can't go past zero so on the downside I do have sort of a defined risk my stock can't go past zero so I can't lose more than my downside break even if the stock does go to zero which would be 68 50 and all I did there to calculate that is take my dollar 50 credit and move it over from my short strike so since we're selling premium that's always going to help our breakeven because we can use that credit we collected to offset any losses we might see with a strike that's in the money so when I'm looking at the short premium of dollar 50 to calculate my breakevens here I'm just taking a dollar 50 subtracting that from 70 to get 68 50 on the downside and on the upside I'm actually adding the dollar 50 because when we're looking at a short call that's equivalent to short shares so if I'm selling a dollar 50 worth of credit I just add it on to there because my losses are going to start coming up here as opposed to a put where they would be realized below the strike price my break even then is 68 50 and 90 150 on this trade and when Max loss is unlimited again because there is no cap to where the stock can go a stock can't go below zero but it can go to 100 200 300 so there's no cap on the upside here which is why we list our max loss as unlimited now let's go to the next slide and we'll talk about an aspect of the trade that is often overlooked and that is implied volatility increasing so one opportunity that we have when we're seeing marked losses specifically with this trade is that it gives us an opportunity to scale into that so when we're talking about trading and lot sizes maybe you'll hear Tom refer to it as a tranche really what we're talking about is segments of our overall contract size so if I sit if I'm able to trade maybe a five lot let's say my default size is a five lot instead of going all five contracts at once into this trade maybe I would look to deploy two at once and then maybe another two and then maybe one or maybe three at first and then another two what that does is it gives me a lot more flexibility to manage this trade in a much better way so let's take a look at this one when we're talking about an implied volatility increase so I've got my original trade listed here where I'm collecting a dollar fifty credit I'm selling out of money put and also an out of the money call and these strikes are at 70 and 90 when implied volatility increases all that is doing is reflecting what's happening in the option price market so if implied volatility is increasing that means that the option prices have increased as well so what that means is that I can probably go farther out in time or actually in the same expiration I can go farther out in terms of strike prices and collect that same credit so if we think about implied volatility as the bell curve we see it on the dough trade page if implied volatility increases you're going to see the bell curve widen out and that's because the probabilities are going to be correlated with the chances of a stock price reaching that strike so if implied volatility is increasing what that is essentially meaning is that the stock price has a chance to go up even higher or down even lower because implied volatility is just looking at the range of where a stock price may go or the one standard deviation range where the stock price may go over one year's time so if implied volatility is increasing you're going to see the probabilities also increase on that on those further out strikes but the prices of those options should increase as well so what does this mean for us what this means is that instead of just layering on another trade on these same strikes sure we could totally do that if I did that scaling into implied volatility I would probably collect enough more than $1 50 credit if I stuck with these same strikes but what I wanted to illustrate here is if five days passed and we see implied volatility has increased significantly which would show me a marked loss on this trade because if the option prices have increased if I sold them here option prices have increased then I'm going to see a marked loss because when we're selling premium we want the prices to decrease so we can buy back that spread for a lower price to reap those profits but if implied volatility has increased that's indicating that the option prices have increased so maybe a different way we can scale into this is by looking to collect the same credit and in doing so we're able to move much further out so as you can see I can move my call three points further out and I can also move my put three points further out and let's say that's giving me that one $50 $150 credit that I'm looking for so how does this affect all of these values down here well number one my max profit is going to be three dollars now because I have two contracts now I've got two strangles on while they do have different strikes at the end of the day I do have to strangle still my breakeven is going to benefit because I'm collecting that additional dollar 50 my break evens now move to my short strikes here and you might be thinking to yourself well if I'm collecting this premium shouldn't my shouldn't my break evens be further than these strikes well normally it would if we were selling this same strikes here if I was selling the same strikes of 90 and 70 then my breakeven would be further out here but since I'm moving my strikes out which gives me a higher probability of profit on this specific trade what we need to do is consider the fact that yes my breakeven was originally 90 150 up here so if the stock price goes to 93 on this trade I would see a hundred and fifty dollar loss and I would be collecting $150 here so if I have 150 dollar loss on this trade and I've collected 150 dollars here my real breakeven if I have both of these trades on is going to be right at this short strike so 93 on this side and 67 on that side my max loss is still on limited again the stock price can't go below zero but a stock can go well above the strikes you have listed here so the loss is still considered to be unlimited because we don't have that defined risk on the call side or the defined risk on the put side one important thing to note though is that now instead of having a one lot of this strangle I now have a two lot with different strikes so if the stock price does end up going past these strikes we're going to see the losses accelerate to 2x2 the speed we would normally see if we just had the one contract but if I'm able to trade up to five contracts in my personal portfolio then being able to scale into this implied volatility increase is going to give me a much better chance to be successful in the long run and another important note on this specific adjustment is that my max profit is going to be realized still if my stock price is between 70 and 90 as we know our breakevens are at 93 and 67 so if the stock price ends up anywhere between 90 and 93 we're going to be able to realize a profit but less than that max profit here so the max profit is still going to be when the stock price is between 70 and 90 because that's when all four of these contracts would be able to expire worthless let's go to the next item we'll look at a totally different example and we're going to look at if the stock price goes down so again we have our original trade here but what happens if over about 20 days here the stock price goes from 80 to 69 so what we've shown to do on tastytrade and what we've shown has been profitable with our back tests up from the research team is to move the strike down so move the untested strike down and if you ever wonder what the untested or tested strike is in this specific example the put strike would be the tested strike because the stock price has gone from being in the middle here going all the way down to the put strike which is now being touched so the put side is going to be the tested side and since the call side is going to be the profitable side it's going to be the untested side so that's another way to think of it whichever side is the losing side of a neutral strategy is going to be that tested side and whatever side is going to be winning side is going to be the untested side so let's say we close out this call here and we roll it down to the eighty one strike for a forty five cent credit since I have twenty six days to go I might want to stay in the same cycle we have shown that when we're going we're getting down to the expiration maybe there's seven or ten days maybe that's when I would move my strikes out in time but if I'm able to capture a credit just by moving my strike down here then maybe I would stay in the same expiration cycle and it's also important to assess my assumption as well so do I think the stock price can get back in between this range in 26 days personally I would say sure because it's right now at 69 and my stuff my strikes are at 70 and 81 now which is really important to understand when it comes to my breakeven so if we look at the credit we received a 45 cents of course we would add that on to our original credit of a dollar 50 to bring our new max profit to a dollar 95 however our new max profit is not realized if the stock price is between 70 and 90 anymore because we rolled our call side down we closed out the 90 strike we rolled it down to 81 so for us to realize this new Max profit of a dollar 95 I need the stock price to be between 70 and 81 it can be at 70 point zero zero or 81 point zero zero as long as it's not one penny in the money both of these options would expire worthless and we would realize that Max profit of 195 which is just a summation of the credit we received when we look at our breakevens on our downside we're actually benefiting from this trade from this roll here because our new max profit and our total credit is a dollar 95 I can now subtract that from the put strike which brings my breakeven on the down side all the way down to 60 805 and since we rolled our call side down from 90 to 81 our breakeven is no longer in the 90s it's important to realize that our breakeven is now at 80 to 95 and all I did there was take my total credit of 45 cents and that to the dollar 50 credit I originally received and then just add that to my strike price here my max loss is still in because again we are not defined risk especially to the upside this is just a closeout of the 90 call so we don't have a spread here we're just moving our short call down and now we have a strangle at 70 and 81 as opposed to 70 and 90 but since we were able to collect a credit and increase our Max profit and move our breakeven down past where the stock price is even further than that this is a nice adjustment to make especially when we're tested on one of the sides so we've got a situation where the stock price or the strike price was tested we also have a situation where we scaled into implied volatility let's see what we can do on the next slide if we combine those things so we've got a combination of those things and we're looking at only seven days to go so at this point what I'm really going to do is assess what I think about this trade I've got the stock price actually at 70 instead of 69 so it's right it's sitting right on my short put so one thing that I might want to do is capture the profit that I originally received on the trade and if my assumption is changed or if my assumption is still the same that it's going to stay pretty range bound or the stock price is going to stay range bound and implied volatility has increased so much that I'm looking around on the trade desk and I can see that with the order chains I'm looking at a straddle comparing it to a strangle and I can see that I can keep or I can roll my put out in time to a new 45 days to expiration cycle and I can also sell a call on the 70 strike in the 45 days to expiration cycle and I can collect a whopping $6 credit so the stock price is trading at 70 I can collect a $6 credit because implied volatility is so high so maybe I would go ahead and assess my position if I think it's still going to be range bound and I still want to be in this position maybe I would look to sell a straddle instead of a strangle we know that straddles are going to best take advantage of an implied volatility contraction because when we look at that bell curve of the probabilities it's also pretty inherent of where the extrinsic value is the most extrinsic value is right in the at the money strikes and when we know extrinsic value is just a reflection of implied volatility and time if we see an IV contraction we should see those middle strikes contract the most so maybe I would look to create a new trade where I'm collecting a six dollar credit and I've got a break-even now of 64 and 76 I'm just taking that credit and moving it to the down side to determine my downside breakeven and adding it to that 70 strike and 70 stock price to determine my upside breakeven but my max loss here is still unlimited because it is an undefined risk trade so let's wrap all these together with some takeaways for you the first takeaway is that IV expansion can create opportunities even when we see marked losses so we hear this all the time especially on the support desk when implied volatility increases or maybe a position just shows a loss even when the stock strikes have not been breached well maybe that would be an opportunity to scale into that if implied volatility is increased it may give us a better chance to be successful if we're selling premium in a higher environment than we already were before another thing to take away is to always be aware of the breakeven when we saw that when we rolled that call strike down we move the breakeven pretty significantly although we did adjust our breakeven to the downside pretty nicely we did move our breakeven on the upside down about nine points so it's important to consider that and lastly if we're getting to the tail end of a trade it's important to reassess our assumption decide whether we want to stay in that trade or get out and move our capital elsewhere so thanks for tuning in this has been three short strangle adjustments hopefully you enjoyed it if you've got any questions or feedback at all shoot me an email here or you can tweet me at dough trader Mike we've got Jim Schultz from theory to practice coming up next so stay tuned hey everyone thanks for watching our video if you liked this video give it a thumbs up or share it with a friend click below to watch more videos subscribe to our Channel or go to our website

Channel: tastytrade

Views: 89,993

Rating: 4.8932624 out of 5

Keywords: short strangle adjustments, short strangle with adjustments, trading tutorial, options tutorial, options trading tutorial, short strangle, short strangle option strategy, short strangle strategy, short strangle management, options trading, strangle option strategy, short strangle adjustment strategy, option strategies, options trading strategies, strangle, short strangle risk management, short strangle options, strangle adjustments, tastytrade

Id: D7E3EKlc40g

Length: 17min 43sec (1063 seconds)

Published: Wed Apr 13 2016