A Word on Strangles as Neutral Strategies
Although long and short strangles differ in their response to market movement, we have chosen to list both as neutral strategies. However, since a $10 move in either direction will have the same impact on profit, the trader doesn't necessarily have a preference which way the market moves. In this sense, the trader is neutral about market direction--as long as movement occurs.
Short strangles are comparable to short straddles in that they profit in stagnant markets with little price change. Like short straddles, they have unlimited loss potential on both the upside and downside. Strangles are slightly less risky than straddles, but the position is far from riskless. In fact, the strangle got its name in 1978 when a number of IBM option traders holding this position lost everything as a result of wide, unexpected price swings.
Let's imagine that a particular stock is trading at $65 per share. The following chart shows where the near-the-money and at-the-money options are trading.
Stock @ $65
Calls and puts have the same expiration
|Sell 1 60 Put @ $2.25||($225.00)|
|Sell 1 70 Call @ $2.50||($250.00)|
If we opted for the strangle, we could sell the 60 put for 2.25 and the 70 call for 2.50. Thus, our maximum profit would be 4.75 less commissions. With the stock anywhere between $60 and $70, we would keep the 4.75 premium we collected by initiating the position. Anywhere below $55.25 or above $74.75, the position will begin to show a loss.
Value at Expiration:
|Stock Price||Profit (L)|
The short strangle can also be created using in-the-money options. This particular type of strangle is sometimes referred to as a "guts." Using the example above, this would involve the following:
Short Strangle (less common alternative)
Sell one 60 call @ $7
Sell one 70 put @ $6 3/4
This is an interesting position for a number of reasons. First, the position is guaranteed to have some value at expiration because at any price at least one of the options will have intrinsic value. More specifically, with the stock between $60 and $70, the options will be worth $10. Thus, the maximum profit will be 3.75 (13.75 - 10) or $375. However, the person who sells this strangle would have the benefit of the interest earned on the entire $1,375 premium collected.
It's also worth noticing that although the maximum profit using in-the-money options is lower (3.75 vs. 4.75), the person holding this position would earn more interest income because they would have collected $1,375 instead of $475.
In the second example, the 60 call and the 70 put each had $5 of intrinsic value with the stock at $65. When you subtract the intrinsic value from the total price of the options, you see that the time premium for the in-the-money options is lower than the time premium for options equidistant from the current stock price but out-of-the-money.
|Option||Price||Intrinsic Value||Time Premium|
View our long strangle page.