After we enter a short strangle, we go into position management mode. But first things first, what exactly can happen to our short strangle position if the price of the underlying starts to whipsaw? Let's review the profit-and-loss graph first and then I'll give you a real-life example of what we can expect to make with short strangles. As with every profit-and-loss-graph in options trading, the one highlighting the profit and loss potential of short strangles is way too unnuanced and scares off many retail investors.
Selling a strangle implies selling an OTM put and an OTM call with the same expiration date (without requiring additional margin when selling both options instead of one). By doing this, we've now created a defined win area, but have unlimited risk if one of the strikes gets breached, but that's deceiving. We receive two times premium from the call and put side. Our breakeven at the lower end of the range is the put strike minus the total premium received for the call and put and vice versa for the upper end of the range.
Compared to put selling or covered call writing, one would think that the strangle does seem less attractive because our win area is defined whereas short puts reach their max. profit as long as share value remains above the put strike.
If we sell a put with a delta of 20 (with plenty of days to expiration), the options will increase in value by 20 cents if the underlying starts declining by 1 dollar. The opposite is also true: an increasing share price will cause our short puts to depreciate. You'll notice that this introduces directional risk. If we want to cancel out the devastating impact from a declining share price on our options position, we can buy a put option (thereby creating a risk-defined strategy) or sell an OTM call to offset our long delta. As a result, when movements in share value are not that significant, the short put and its long delta will offset the short call and its short delta. To put another way, when movements in share value remain moderate we don't have a directional exposure to the underlying. We just capture time value and benefit from our short Vega (volatility greek) position. In that regard, you won't squeeze a lot of money out of your short strangle just a few days after you entered the trade (in case of no earnings report). It's a tradeoff between generating a really fast profit but also facing potentially significant losses and collecting time value while keeping your directional exposure under control.
My Approach To Selling Strangles
The higher the deltas of the options you choose, the higher your total premium, the lower your win rate and the narrower your profit zone will be. Therefore, I'd like to stick to initial deltas of 10-15 to create more room to manage the trade throughout the lifecycle. If you are way too aggressive in setting your initial deltas, things can turn out to be very creepy. Also, I already own a buy and hold stock portfolio which means I don't want to take on even more risk by owning high-volatile stocks or selecting elevated deltas (which measures directional risk to the underlying you sold options on). However, one exception to the rule would be an earnings play like I did with Broadcom (AVGO) last week to play out the impact of a collapsing implied volatility on options prices. The reasoning behind this? Implied volatility will affect options prices more than the changing share price itself, at least if you don't pick strikes with high deltas. The more defensive you are, the more you can controle your outcome and make adjustments along the road.
Managing Short Strangles Throughout The Lifecycle Of The Trade
Now, let's go back for a second and review the profit-and-loss graph for the short strangle and the short put. By selling a put option, we receive a specific amount of cash premium and as long as share value remains above the strike, we can count that entire premium as maximum profit. A big win area, isn't it? But what if the price starts dropping precipitously? In case of a plunging share price, our long delta will increase along the way and our short put position will start to mimic a pure stock position. I don't want to face the same risk as a common shareholder. That's why I sell short strangles to wipe out the impact of a changing share price. That significantly reduces volatility in your daily P/L figure. Also, what the chart of the short put doesn't tell us is that management is a lot tougher when the market starts turning against us. We might consider rolling down the short put (buying back your options and selling a lower strike), though, our profits will dwindle. When selling strangles and cherrypicking deltas of 10-15, we can roll up the puts if our delta has dropped below 5 or so because of a rising share price. If shares drop a little bit and cause the delta of our short call to depreciate to 5, we can roll down our short call and make our win area smaller in exchange for a larger premium, thereby lowering our breakeven level on the put side. This will result in a new well-balanced portfolio and implies we don't have a directional opinion on the stock, while it adds additional premium to the portfolio and helps offset potential losses.
Let's have a look at one of my real-life trades I made with Nextera Energy on . I first sold the 200/230 strangle expiring on October 18. NEE shares were then trading at 217-218 dollars. My initial credit was 90 cents for the 200 puts and 82 cents for the 230 calls. Just a few days later, I rolled up my puts because their delta had diminished to just 6. I bought back the 200 puts for 50 cents and sold the 210 puts for 1.20 dollars. NEE continued to rise moderately and I rolled up once again to the 220 puts. I bought them back at 63 cents and sold the 220 puts for 1.90 dollars.
My initial credit was 1.72 dollars for the 200/230 strangle, but by rolling up the 'untested' side I was able to lock in another 1.97 dollars. That caused my breakeven point on the call side to increase from 231.72 to 233.69. My breakeven on the put side is the strike price of 220 minus 3.69 dollars is 216.31. From a graphical point of view, I've widened my win area on the call side.
The issue 'How do we manage our options positions heading to the last week before expiration' will be tackled in the next article.