What is a Short Strangle & How do I Trade it?

hello everyone and welcome back to Mike and his whiteboard my name is Mike this is my whiteboard and today we're talking about short strangles so we finished up our discussion for the mean time of the Greeks so we talked about Delta Gamma theta now we're going to talk more about some strategies so a short strangle is a high probability trade that you'll see us doing here all the time it's a premium collecting or premium selling trade so we're all about it here at tastytrade especially in high implied volatility environments so what we're going to do today is basically break down the concept totally and we're going to construct it back up so we're going to talk about why this strangle works and why when we're selling a put in selling a call the two are basically battling each other throughout the trade so we'll show that to you visually here so let's get right into it and discuss what it's made up of so a short strangle is essentially selling two out of the money options and out of the money put and an out of the money call to create a profit zone so when we're looking here we can clearly see we've got a short put and again a put contract is the option or right to sell 100 shares of stock if someone owns that put so if we're selling a put we want the shares of the stock to go up and that's because if they have the right to sell the shares to me then I'm going to want that stock price to go up and stay out of the money because if they can sell their stock in the market for a higher price than they would using my option that I sold them then that's going to be good for me I'm going to keep that credit entirely and it's going to be a profitable trade so the first aspect of a short strangle is a short put as you see here now we've got the arrow a little further to the left than the actual strike that we sold and that's because of our break-even point so breakeven is another concept we're going to talk about next week we're going to break it down totally but basically it's great to know that when we're selling premium our breakeven price is going to be working for us you can see that we actually can profit even if the stock price goes if it breaches our short strike of the short put right there and that's because we've collected a credit that we can use to offset that so again when I'm selling a put I want the stock price to go up and that's because when the stock price is going up they the other party of the contract can sell their shares at a higher price than they can exercising the option I sold to them so my option would be out of the money or worthless at expiration and I can keep that credit that I sold it to them for now let's take a look at a short call so we've got the out of the money put on the left side here and what we also do to create a strangle is sell and out of the money call so an out of the money call is just the opposite if I sell a call above the stock price which is out of the money for calls I'm going to want that stock price to go down so if we review what a call option is it's basically the right to buy 100 shares of stock at a certain strike so if my strike is above the stock price right now it's out of the money and that's because whoever bought this call can buy their shares actually for a lower place lower price right now so they would be actually paying a higher price if they exercised that option so it doesn't make sense which is why it's out of the money it has no real intrinsic value so because of that I'm going to want that stock price to go down or stay the same or you can even go up a little bit and breach the strike just like the short put because I received that credit for the call as well and that's going to help me overall in the long run so now we know what a strangle is it's a short put a short call and that creates a profit zone here so you can see when we add these two together we've got a profit zone that's created so we've got a short put where we want the stock price to go up stay the same or go down a little bit and we've got a short call where we want the stock price to go down stay the same or go up a little bit so what we've got here is a zone of profitability so all this is about is being delta-neutral so a strangle is a delta-neutral trade if we place it equally on both sides and we talked about this when we were talking about Delta so this basically has no directional assumption right now we're right in the middle of that stock price and we've got a short call the money on the above side and we got a short put below there and that basically creates the range that we can be profitable because at expiration if these two expire out of the money we collect and keep the total credit that we collected originally and that would be our profit so what we're going to do now is basically walk through what a short string might look like through the life cycle of a trade so if we go to the next slide what I want you to visualize here is we've got a start and finish line we've got our short put strike on the left side our short call strike on the right side and what I want you to think about is this squiggly line being the stock price so we're going to start where we've got that neutral trade there's no bias to any side so it's a delta-neutral to begin with and when we start out you can see that the stock price is starting to creep closer to the put side so what you'll see through the life cycle of the trade is the short put and short call are going to be battling each other constantly throughout the trade because again they are different totally opposite assumptions when I sell a put I want the stock to go up when I sell a call I want the stock to go down so since they're battling each other you're going to see different pnls for each of these strikes but at expiration we're going to talk about what will happen as long as the option the stock price stays within the short strikes so just starting out you can see if the stock price starts to go towards the put side what you'll see is a loss on the put side and a gain on the call side and that's because if I sold a put for a certain level and then the stock price starts to go down that's going to increase the value of the put so if I sold the put here and now the value of the put is higher since I sold the put to begin with to close the trade I need to buy it back so if I sell it for a dollar and I have to buy it back for a dollar 50 that's going to be a $0.50 loss there so what you'll see is when the stock price is going towards the put or testing the put you're going to see a loss on the put side but since we want the stocks to go down for the call side you'll see a gain on the call side now as we go through time you'll see the stock price is going to differentiate and basically swing both ways so let's say it goes all the way back up and starts testing the call side now what you might see is possibly a loss on the call side but a gain on the put side and you see I've got three dots on the left side and two dots on the call side so as the trade goes along regardless of where it is you're probably still going to slowly see a profit overall so I've got the put profit outweighing the call profit here and that's because at expiration as long as it stays between the strikes we're going to be profitable in the end so you might see marked losses which is what these are all these red dots here throughout the trade life cycle is just a marked loss because the stock price is still out of the money or between the two strikes on each side we're going to see a marked loss on maybe one of these but overall we could probably still see the trade as being profitable as long as there's not a huge spike in implied volatility so as we're moving along let's say it swings right back down to the put side so now you might see that the put side is losing but the call sign is gaining and since it's out weighing the put side we can still see an overall profit and as we creep to the finish line or expiration as long as the stock price is anywhere within this range we're going to see profit on both sides and profit in general on the entire trade so that's really the key here is when you have this trade on we get this question a lot in support with iron condors or strangles all together whenever one side is being tested even if it's still out of the money you might see a loss on one side and a gain on the other but since we put this trade on as a package we always like to take it off as a package so I wouldn't want to be closing my call side when I'm seeing a loss on the put side or vice versa because now I don't have that that neutral range I have a bias trade then so I would be going from neutral to bullish or neutral to bearish so we always like to put our trades on as a package and take them off as a package so I just wanted to give you this visualization to see how this might act throughout the life cycle of a trade so let's break this all down and recap what a strangle is here so essentially again the strangle is just the sale of an out of the money put below the stock price with an out of the money call above the stock price and that's going to give us a net credit since we're selling both options and it's going to give us a profit range here so we've got our breakevens noted here so you'll see that our profit zone is actually going to exceed our strikes and you'll see that on the dough platform as well and that's because it's accounting for the break-even price and the credit that we received when we actually place the trade so our first takeaway is that a strangle combines a short put in short call to create a profit zone so again since we're selling both of these options although they'll be battling each other that you might see throughout the lifecycle of the trade as long as they stay out of the money or within our breakeven zones we're going to see a profit at expiration one key takeaway is that this is an undefined risk trade and that's because we have a naked call and a naked put while stocks can only go to zero so theoretically a naked put is still defined at zero a naked call is undefined because a stock price can go to anything it can go from 20 to 80 overnight there's no cap on the upside in terms of where a stock can go so this is considered an undefined risk trade and last but not least max profit is realized if options are out of the money at expiration so again since both of these options are sold out of the money there's no intrinsic value and when we're at expiration the only thing that can be exercised is intrinsic value so since these options are out of the money as long as they stay out of the money at expiration we're going to keep the entire credit we received and at expiration if it goes through the actual expiration date you'll see those options just disappear from your portfolio and that's because there's no way that can be exercised so there's no exercise fee or closing fee they just disappear because they're worthless so this has been strangles hopefully this was a great visualization for you on Tuesday we're actually going to talk about inverted strangles so we had a viewer Frank who wanted to know about inverted strangles so we're going to take this strangle that we just learned about and we're going to talk about how it can be inverted over management over time so it's going to be a great segment on Tuesday thank you so much for tuning in if you have any feedback at all shoot us an email at support at doe comm support at tastytrade.com or you can tweet us at doe trading at mic or at tastytrade and thanks again have a great night hey there hope you like this video click below to watch more videos subscribe to our channel and check out tastytrade.com for more great research and content

Channel: tastytrade

Views: 89,634

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Keywords: short strangle, short strangle option strategy, short, strangle strategy, short strangle management, short strangle adjustments, options trading, strangle option strategy, how to trade options, short strangle adjustment strategy, option strategies, stock market, options trading strategies, options, selling options, options trading for beginners, strangle, short strangle risk management, short strangle options, option trading for beginners, tastytrade

Id: dNv1UYRawB8

Length: 11min 31sec (691 seconds)

Published: Tue Feb 02 2016