The Magic of Selling Strangles

The Magic of Selling Strangles
Dec

14

2017

The Magic of Selling Strangles

Option Selling Institute

With powerful advantages for the seller, a strangle should be a core strategy for your option writing portfolio

Looking for a basic option selling strategy that can give youpotentially higher return on equity and enhanced risk protection?

Look no further than a basic option strangle, a staple strategy for any serious option writer.

A short option strangle is applied by selling both a put and a call in the same market. It is a “go to” premium generator in our portfolios but is also simple enough to be applied by the novice.

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.


…the strangle is a durable strategy able to profit in a wide range of market outcomes with, in many cases, a smooth equity curve.

In a strangle, your put is sold far below the current price of the underlying commodity and your call is sold far above the current price of the underlying commodity. The area between these strikes is known as theprofit zone. If the futures price isanywhere between the two strike prices at expiration, both options expire worthless and the trader keeps all premium collected as profit. Thus, the best markets for selling strangles are markets that offer wide profit zones.

Why Choose the Strangle?

Strangles provide some lucrative benefits not generally available to the pure naked option seller.

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

The concept of the strangle is “bend but don’t break.” Should the market begin to move in one direction, the paper loss on the option being pressured is offset (at least partially) by profits from the option on the other side. Should it reverse direction, the opposite effect occurs. Meanwhile, time decay is eroding both the put and the call , eventually (hopefully) rendering both sides worthless.

In many cases, this “offsetting” effect can allow a wider range of movement in the underlying contract without significantly affecting your equity. Thus, the strangle is a durable strategy able to profit in a wide range of market outcomes with, in many cases, a smooth equity curve.

The example below illustrates a typical option strangle applied to commodities.

Historical Example – Short Option Strangle – May 2017 Natural Gas

GRAPH: Short Option Strangle - may 2017 Natural Gas

(* Note: This hypothetical trade is for example purposes only to illustrate a concept. No representation is made that the trade in the example was actually used or produced a profit.)


Trade date:

November 15, 2016

Trade:

Selling May Natural Gas 2.60 put and 5.60 call (Strangle)

Total Premium Collected:

$1,600 ($800 put, $800 call)

Margin Requirement:

$2,210

Option Expiration:

April 26, 2017

Analysis:

If price of natural gas is anywhere between 2.60 and 5.60 per mbtu 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

Secondary Benefit: Potentially Higher ROI

A secondary benefit of writing a strangle is potentially higher return on your invested capital. This is made possible by the way the exchanges treat margin requirements for strangles.

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 May Nat Gas 5.60 call:

$1,515

Margin Requirement for writing May Nat Gas 2.60 put:

$1,160

Total:

$2,685

Margin Requirement for writing May Nat Gas 5.60 call/ 2.60 put Strangle

$2,210

Net Margin Gain

$475

Thus writing the put and the call together, provides a higher potential return than just writing either side individually. This is a big draw for serious option sellers.

Drawbacks and When to Use Strangles

Like any strategy, strangles have their limitations. The downside of the strangle, of course, is that a steep breakout in either direction can result in a loss. 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 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.

GRAPH:

Strangles are a durable strategy able to plow through a variety of market conditions.


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. However, fundamentals remain the key ingredient. High volatility is not always necessary to effectively write commodities strangles.

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

Conclusion

Strangles can be a powerful tool in the hands of a competent option seller. But they are also simple enough to be employed effectively by the novice.

Strangles can offer you the dual benefits ofhigher profit margins and added downside protection.

It’s a versatile, robust strategy that can stand up to plenty of volatility and still bring your premium home.

No strategy is perfect, of course. But strangling is a good example of the magic that can occur when combining multiple options in the right way.

(Watch for Michael Gross’s video lesson on writing option strangles, coming to the blog in December! www.OptionSellers.com/blog )


Michael Gross is Director of Market Research at OptionSellers.com in Tampa, Florida. He is co¬author of the book The Complete Guide to Option Selling 1st, 2nd and 3rd Editions (McGraw-Hill 2015).

With over 18 years of experience in futures and options, Michael is a regularly featured guest author in a variety of financial publications. Michael’s published works on option selling in the commodities markets have appeared on Yahoo Finance, Forbes.com, Businessweek.com, Optionetics.com and Futures Magazine. His market comments have been featured by Barron’s, The Wall Street Journal, Reuters World News, Dow Jones Newswires, Kitco, and Fox Business News.

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