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Short Strangles: Making the Most of Sideways Markets

Short Strangles: Making the Most of Sideways Markets

Key Points
  • Short strangles allow you to potentially profit by taking a neutral position. 

  • Consider short strangles if you expect a sideways market or decreasing implied volatility.

  • Find out how to construct a short strangle.

Short strangles are similar to short straddles, except that with short strangles, the short call and short put are both out of the money at the time they are sold—with short straddles, either the call or the put will typically be in the money, unless they're both exactly at the money.

Most long options, uncovered (naked) options and spreads are typically directional strategies, meaning each strategy is either bullish or bearish. A short strangle, on the other hand, is a neutral strategy—neither bullish nor bearish, instead seeking to capitalize when prices are reasonably stable.

This means that when you establish a short strangle, you're hoping the underlying security stays flat or moves very little. Short options also benefit from a decrease in volatility (an estimate of how the price of the underlying security may change), and with short strangles you're short both puts and calls.

Let's walk through how to create a short strangle, how they work and when to consider using one.

Creating a short strangle

Like a short straddle, a short strangle is the sale of an uncovered call and an uncovered put at the same (or nearly the same) time, except with a short strangle the put and call options have different strike prices. A short strangle can be entered as a multi-leg order for a single net credit amount, or the two options can be sold separately.

How short strangles work

The mechanics of a short strangle are virtually the same as a short straddle, the key difference being that a short strangle typically brings in less money initially, but expiration of both options can occur over a greater range of prices. As a result, it's more likely that the trade will be profitable because a short strangle allows for the underlying stock to move more in either direction. However, the profit when this occurs will generally be smaller.

The ultimate goal of a short strangle is also very similar to a short straddle: to have the underlying security end up at a price where both options expire worthless at expiration. While there's a better possibility this can happen than with a short straddle, a short strangle will still be profitable if the underlying stock closes in the money by a small-enough amount on either option, such that the loss on the in-the-money option will be less than the initial net credit received when the strangle was established. The amount that the stock can end up above the call strike or below the put strike and still generate a profit depends on the premiums received for each option at the time the strangle was established.

Short strangle example

  • Assume the underlying stock XYZ is trading at $73
  • Sell 10 XYZ Jun 70 puts @ 0.50
  • Sell 10 XYZ Jun 75 calls @ 1.00 for a net credit of 1.50

This strangle is executed for a net credit of $1,500 (0.50 points premium received on the put + 1.00 point premium received on the call x 10 contracts x 100 shares of stock per contract). In the graph below you can see:

  • The trader will profit if the market price of XYZ closes between $68.50 and $76.50 by option expiration.
  • The potential for loss to the upside is theoretically unlimited.
  • The potential for loss to the downside will increase until the price of the underlying stock reaches zero.
  • The maximum gain will be realized if XYZ closes anywhere between $70 and $75 at expiration.

A short strangle in action

A short strangle in action

Source: Schwab Center for Financial Research. 

Keep in mind

  • If the trader had simply sold the May 70 puts naked, he would have initially brought in only $500 (rather than $1,500) and would only be able to make a profit if the stock ends up above $69.50 at expiration.
  • If the stock closed anywhere below $70 at expiration, the put would expire in the money and would probably be assigned, resulting in a long equity position at a price of $70. The trader would then have a loss of the difference between the current market price of the stock, and the strike price of $70—less the original premium received. He would then have to decide whether to hold the stock position (for an unrealized loss) or close it out (for a realized loss). The outcome would be similar with the short strangle, except that the loss would be reduced by the premium received on the sale of the call option.
  • In addition, if he simply sold the May 70 puts naked, he would profit at all prices above $69.50, but his maximum profit potential would also only be $500, rather than the $1,500 he could potentially make on the short strangle. The $1,000 of reduced profit potential is the trade-off for eliminating the possibility of taking a loss to the upside (theoretically, a potentially unlimited loss).
  • Similarly, if only the short call were sold naked, profitability would occur at all prices below $76, but the maximum profit would be reduced to only $1,000.

Once a short strangle is established, it's typically held until expiration since the goal is for both options to expire worthless. However, as with any option strategy, either option can generally be closed out at any time or held until expiration. In addition, since both options are short, if either one goes in the money (as with any American-style option) it could be assigned at any time prior to expiration.

To understand the profit-and-loss characteristics of a short strangle, let's assume that once it's established, it's held until expiration. Let's examine six different stock prices to draw a clear picture of how this strategy works.

Scenario 1: Assume the stock drops significantly and closes at $65 at option expiration. If this happens, the trader will be assigned on his short 70 puts and acquire 1,000 shares of XYZ stock at a cost of $70,000. At the same time, his short 75 calls will expire worthless. He can then sell his long stock position at the current market price, for net proceeds of $65,000. The difference between his buy and sell price amounts to a loss of $5,000. However, since he initially brought in $1,500 when the strangle was established, his net loss is only $3,500. If the stock had dropped further, the trader would continue to lose money all the way down to zero. At prices below $68.50, his losses will be (the price of the stock - $70) x 1,000 shares + $1,500 initial proceeds.

Scenario 2: Assume the stock drops only slightly, and closes at $69 at option expiration. If this happens, the trader will be assigned on his short 70 puts and acquire 1,000 shares of XYZ stock at a cost of $70,000. At the same time, his short 75 calls will expire worthless. He can then sell his long stock position at the current market price, for net proceeds of $69,000. The difference between his buy and sell price amounts to a loss of $1,000. However, since he initially brought in $1,500 when the strangle was established, he actually has a net gain of $500. His gain will vary from zero up to $1,500 at prices from $68.50 up to $70.

Scenario 3: Assume the stock closes at exactly $70 at option expiration. If this happens, the trader will probably not be assigned on his short 70 puts because they are exactly at the money. He also will not be assigned on his short 75 calls because they are out of the money. In this scenario, both options expire worthless, and the entire $1,500 initial proceeds is retained. The maximum gain of $1,500 occurs at any price between $70 and $75.

Scenario 4: Assume the stock stays unchanged and closes at $73 at option expiration. If this happens, the trader will not be assigned on his short 70 puts because they're out of the money. He also will not be assigned on his short 75 calls because they are out of the money. In this scenario, both options expire worthless and the entire $1,500 initial proceeds are retained. The maximum gain of $1,500 occurs at any price between $70 and $75.

Scenario 5: Assume the stock rises a few points and closes at $76 at option expiration. If this happens, the trader will not be assigned on his short 70 puts because they're out of the money. However, he will be assigned on his short 75 calls and end up short 1,000 shares of XYZ at a price of $75,000. The trader can then buy back his short shares at the market price of $76, for a net cost of $76,000. In this case, the difference between his buy and sell price amounts to a loss of $1,000. However, since he initially brought in $1,500 when the strangle was established, he actually has a net gain of $500. His gain will vary from $1,500 down to zero at prices from $75 up to $76.50.

Scenario 6: Assume the stock rises substantially and closes at $78 at option expiration. If this happens, the trader will not be assigned on his short 70 puts because they're out of the money. However, he will be assigned on his short 75 calls and end up short 1,000 shares of XYZ at a price of $75,000. The trader can then buy back his shares at the market price of $78 for a net cost of $78,000. In this case, the difference between his buy and sell price amounts to a loss of $3,000. However, since he initially brought in $1,500 when the strangle was established, his net loss is actually only $1,500. If the stock had risen even further, the trader's loss potential is theoretically unlimited. At prices above $76.50, his loss will be ($75 - the price of the stock) x 1,000 shares + $1,500 initial proceeds.

While the examples above deal with the outcome of this strategy at expiration, you're generally not required to hold either leg of a strangle position until expiration. Here are a few additional outcomes to consider:

  • If the underlying security moves substantially in one direction, you may be able to close out either leg of the strategy at a profit prior to expiration.
  • If the underlying security moves substantially in one direction and then reverses course and moves substantially in the opposite direction, it may be possible to profit on both legs if they're closed at the proper times.
  • As time value erodes the value of both options as expiration approaches, you might also choose to close out both legs early, at the same time, if it can be done at a net profit.

Remember, since you're short both options once you establish a short strangle, time value erosion will work in your favor. Keep in mind, however, that if either option goes in the money, you could be assigned at any time prior to expiration.

Short strangles as a neutral or Theta strategy

As a neutral or Theta strategy (a strategy intended to take advantage of time decay) a short strangle makes sense if you expect little or no news that could make a stock move. For example, you might establish a short straddle a few weeks after the company has released earnings, when the big moves associated with the earnings report have already taken place and the next earnings season is a couple of months away.

Short strangles as a volatility strategy

As a volatility strategy, a short strangle is typically established just before an earnings release (when implied volatility has climbed to relatively high levels) and then closed out just after the earnings release. The ideal stock on which to execute this strategy may be one that plans to release earnings before market open on a specific day.

In this case, the short strangle should be established near the end of the prior trading day and closed out the next morning after the earnings have been released, as the implied volatility typically drops sharply at that time.

For example, in the chart below you can see the typical implied volatility increase in the days leading up to the earnings report, reaching a peak of 104% on the day just before the report. Earnings were released the next morning before market open and the implied volatility dropped to 51% that day. If the short strangle had been established late on the day before the earnings release and closed out the day of the release, the option prices would likely have dropped very sharply. You can forecast this price change estimate using the Theoretical View Tool available in the options chains on StreetSmart Edge®.

Keep in mind, if a large directional movement occurs as a result of the earnings report, the loss on one option could be enough to eliminate the gains due to the volatility reduction. This strategy works best when the earnings report ends up being relatively in line with the earnings estimates.

Decrease in Implied Volatility

Decrease in Implied Volatility

Source: StreetSmart Edge®.

Bottom line

Short strangles can have both advantages and disadvantages over other speculative strategies, such as naked puts or naked calls alone.

Among the advantages:

  • You can often increase your profitability if the underlying security remains stable, because risk has been taken in both directions rather than in just one.
  • With a very stable stock, it may be possible to profit on both options if each is closed out at the proper times.
  • Decreases in volatility can boost profitability, since decreased volatility causes the value of both calls and puts to drop, and this strategy is short both calls and puts.
  • Time value typically works in your favor on strategies involving short options. Since this strategy involves both short puts and short calls, both will typically benefit from time value erosion.

The primary disadvantages:

  • Because two different options are sold, commission costs will be higher than single-leg strategies.
  • The higher profit potential also increases the likelihood that a loss could be incurred, since you would be exposed to both upside and downside risks.
  • Increases in volatility can cause greater losses, since increased volatility tends to cause the value of both calls and puts to rise, and this strategy is short both calls and puts.
  • Because this strategy involves uncovered positions, it requires the highest level of option approval available at Schwab: Level 3.
  • Because this strategy involves uncovered options, it requires a substantial margin requirement, which ties up account equity and reduces available trading capital.
  • Because both options are uncovered, there's unlimited risk to the upside and substantial risk (if the stock drops to zero) to the downside.

For more information on short strangles or any option strategy, please contact a Schwab Trading Specialist at 800-435-9050

Next Steps

Schwab clients: Contact a Trading Specialist at 800-435-9050 for questions or log in to the Trading Services Learning Center.
Not yet a client? Learn more about Schwab Trading Services.

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