Selling Strangles to Double Your Premium, Balance Your Risk

Selling Strangles to Double Your Premium, Balance Your Risk
Dec

17

2014

Selling Strangles to Double Your Premium, Balance Your Risk

Selling Puts and Calls in the same Market can provide some unexpected Benefits

A core focus of The Complete Guide to Option Selling 2nd Edition (McGraw-Hill 2009) is pairing the logic of selling option premium with the long term fundamentals of a particular market. While we are confident that this is a winning formula for long term success in the commodities option market, it is certainly not the only formula – another key concept of the book.

At certain times, however, there may be opportunities outside of one’s core fundamental holdings that can offer juicy opportunities for selling options – without necessarily forming a fundamental bias.

WATCH OPTIONSELLERS.COM’s MICHAEL GROSS New Video on Selling Strangles with Commodities Options

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Enter the Strangle

A strangle is an option selling strategy that involves selling both a put and a call at the same time. It is a go to premium generator in our portfolios and should be one for you too.

In a strait up naked option sale, you are picking a point above or below the market where you think prices will not go. A strangle is picking a point above AND below the market, where you think prices will not go. Strangles are best employed in markets that are trading in a range bound price pattern. However, we have also employed them effectively in steadily trending markets.

In a strangle, your put is sold far below the current price of the underlying futures and your call is sold far above the current price of the underlying futures. If the futures price is anywhere between the two strike prices at expiration, both options expire worthless and the trader keeps all premium collected as profit. Although strangles can often produce more premium for the seller than selling naked puts or calls, they can also be considered a more conservative strategy, as gains on one side of the strangle tend to offset losses on the other.

Benefits of the Strangle

  • Double Premium but not Double Margin (Higher ROI)
  • Offsetting Risk Effect makes more stable, durable position
  • Ability to profit over a wide range of price movements
  • Can produce in both trending or non-trending markets
  • Capitalizes on Market Volatility

In many cases, this “offsetting” effect can allow a wider range of movement in the underlying contract without significantly affecting your equity. Meanwhile, time decay gradually erodes the value of both the put and the call.

EXAMPLE – Short Option Strangle – December Natural Gas

graph-strangle-natural-gas-dec
Trade date: July 22, 2014
Trade: Selling December Natural Gas 2.80 put and 6.00 call (Strangle)
Total Premium Collected: $1,600 ($800 put, $800 call)
Margin Requirement: $2,210
Option Expiration: November 25, 2014
Analysis: If price of natural gas is anywhere between 2.80 and 6.00 at expiration, both options expire worthless and seller keeps all premium collected as profit.
Risk Management: Conservative: Risk to one of the options doubling in value (Ideally, the other side would then expire worthless, resulting in the trader breaking even on the trade).

Moderate: Risk to one of the options tripling in value, resulting in an $800 net loss on the trade (assuming the other side expires worthless)

Aggressive: Risk to one side going in the money

• This trade is displayed for example purposes only. It is only to illustrate a concept. No representation is made that these options can or were sold at these premiums during the time period mentioned.


Benefits of Using the Strangle

Also known as “bracketing”, the strangle can be a profitable approach as long as the futures price is anywhere between the two strike prices at option expiration. As stated earlier, the primary benefit of a strangle is this: if the market is heading towards one strike or the other, the increasing value of the nearer strike price is offset, at least partially, by the decreasing value of the option on the other side of the market. This offsetting effect allows the market greater flexibility to fluctuate as opposed selling a straight put or call. Both the put and the call will eventually expire worthless, as long as neither strike price is exceeded.

A secondary benefit is margin. The phrase the whole is greater than the sum of it’s parts is often true when writing strangles. The margin for writing a strangle is often less than the sum of margin for writing a naked put and the margin for writing the naked call. This concept is illustrated below:

Margin Requirement for writing December Nat Gas 6.00 call: $1,515
Margin Requirement for writing December Nat Gas 2.80 put: $1,160
Total: $2,685
   
Margin Requirement for writing December Nat Gas 6.00 call/ 2.80 put Strangle $2,210
Net Margin Gain $475

Thus, writing a strangle can not only be an effective tool in helping to mitigate risk by letting puts and calls balance each other, it can also increase an investor’s return on invested funds due to it’s favorable margin treatment among the exchanges.

Like any strategy, strangles have their limitations. The option on the opposite side of the losing option can only balance losses so far. The balancing nature of the strangle, however, will generally allow risk conscious traders to exit gracefully in such an occurrence if they are using the risk management guidelines listed above.

Strangles can be very effective in markets experiencing high volatility. Volatility can often make strikes available on both sides of the market that have little chance of ever going in the money.

Fortunately for sellers of strangles, today’s markets have no shortage of volatility. Look for markets offering the “ridiculous” strikes and don’t be afraid to sell both sides if there are traders in the mood to buy them.

Option Seller Discovery Kit

To learn more about selling commodities options directly with the Authors of McGraw-Hills The Complete Guide to Option Selling, request our FREE Option Seller Discovery Kit at www.OptionSellers.com/Discovery ($250,000 minimum investment). Your pack includes a special investment plan for high net worth investors, examples of option selling positions and a 30 minute Video DVD.

Learn More about the Kit

James Cordier is the founder of OptionSellers.com, an investment firm specializing in writing commodities options for high net-worth investors seeking outsized returns. James’ market comments are published by several international financial publications and news services including The Wall Street Journal, Reuters World News, Forbes, Bloomberg Television News and CNBC. Michael Gross is an analyst with OptionSellers.com. Mr. Cordier’s and Mr. Gross’ book, The Complete Guide to Option Selling 3rd Edition (McGraw-Hill 2014) is available at bookstores and online retailers now. For more information on managed option selling accounts visit www.OptionSellers.com/Accounts ($250,000 minimum investment)


Price Chart Courtesy of CQG, Inc.


***The information in this article has been carefully compiled from sources believed to be reliable, but it’s accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss, and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.

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