Understanding The Short Strangle Strategy

The Short Strangle strategy involves selling one out-of-the-money (OTM) call option and one OTM put option, both with the same expiry date. This strategy is designed for traders who believe that the market will remain within a specific range and are looking to profit from the theta decay 

In the realm of option trading, strategies abound for those seeking to capitalise on market movements. Having explored the Long Straddle, Short Straddle and Long Strangle in our previous issues, it’s time to delve into the Short Strangle strategy. This strategy, while similar to the Short Straddle, offers a different approach with potentially higher probabilities of success because of wider range. Let’s explore this strategy in detail, with the help of our fictional trader Sarvani Shah, and compare it with the Long Strangle strategy

The Story of Sarvani Shah
Sarvani Shah, an avid trader from Hyderabad, has always been eager to learn and apply new strategies in her trading journey. After successfully experimenting with the Long Strangle strategy, she became curious to know about strategies to profit if the underlying remains within a specified range, seeking higher probability setups that could enhance her success rate. One evening, while discussing trading tactics with her mentor, Rishi Raj, the conversation turned to the Short Strangle strategy. Rishi explained that while the Long Strangle was beneficial for those anticipating large market moves, the Short Strangle could be a better fit for traders expecting a more range-bound market. Intrigued by the potential of this strategy, Sarvani decided to explore it further.

Short Strangle: An Overview
The Short Strangle strategy involves selling one out-of-themoney (OTM) call option and one OTM put option, both with the same expiry date. This strategy is designed for traders who believe that the market will remain within a specific range and are looking to profit from the premiums collected.

Example: Given the following conditions:
▪ Nifty Current Market Price: ₹25,000
▪ OTM Strike 25,200 CE Price: ₹315
▪ OTM Strike 24,800 PE Price: ₹205
▪ Expiry Date: September 26, 2024.

To execute the Short Strangle strategy, Sarvani would sell the 25,200 strike call and the 24,800 strike put options. Here’s what happens:

1. Call Option: Sells the obligation to sell Nifty at ₹25,200
2. Put Option: Sells the obligation to buy Nifty at ₹24,800.

Breakeven Points
The Short Strangle strategy has two breakeven points, beyond which the position will start incurring losses after accounting for the total premiums collected.
1. Upper Breakeven Point: 25,000 + (315 + 205) = ₹25,520
2. Lower Breakeven Point: 25,000 − (315 + 205) = ₹24,480.

This means Sarvani’s position will be profitable if Nifty remains between ₹25,520 and ₹24,480. If Nifty moves beyond these levels, her potential losses could be unlimited.

Payoff Structure
The payoff for the Short Strangle strategy depends on the price of the underlying asset at expiry. Let’s break it down:

At expiry:
▪ If the Nifty price is between ₹25,200 and ₹24,800, both the options expire worthless, resulting in the total premium collected as profit.
▪ If the Nifty price is much higher than ₹25,200, the call option will be in the money, resulting in a loss.
▪ The put option will expire worthless.
▪ Net payoff: (Call option loss - Put option premium received).

If the Nifty price is much lower than ₹24,800:
▪ The put option will be in the money, resulting in a loss.
▪ The call option will expire worthless.
▪ Net payoff: (Put option loss – Call option premium received).

The following table and diagram can help visualise the payoff structure:

Position Management for Short Strangle
1. Profit Zone: If Nifty remains between ₹25,200 and ₹24,800, Sarvani can retain the entire premium collected, making this strategy profitable.
2. Loss Zone: If Nifty moves beyond ₹25,520 or below ₹24,480, Sarvani may face unlimited losses, depending on how far Nifty moves. This is why careful monitoring is crucial.
3. Exit Strategy: If the market starts moving towards the breakeven points, it may be wise to close the position early to minimise potential losses. As expiry approaches, time decay works in favour of the Short Strangle, but sudden market movements can still pose significant risks.

Long Strangle versus Short Strangle: Key Differences

Pro Tips: Straddle versus Strangle
Now that we have covered all four strategies, let’s summarise the differences:

Long Straddle versus Long Strangle Cost versus Probability:
The Long Straddle is more expensive but offers a lower breakeven point, making it easier to reach profitability. The Long Strangle, while cheaper, requires a more significant market move to become profitable. However, for traders who expect moderate volatility but want to limit their upfront costs, the Long Strangle could be a more appealing choice. It allows traders to participate in the market with a smaller investment, potentially leading to a higher return on investment if the anticipated price movement occurs.

Short Straddle versus Short Strangle Risk versus Probability:
The Short Straddle collects a higher premium but carries a higher risk due to closer strikes. On the other hand, the Short Strangle, with its more out-of-the-money (OTM) strikes, offers a higher probability of retaining the premiums but comes with a lower profit potential. For traders who prioritize safety and are willing to accept slightly lower returns in exchange for a higher probability of success, the Short Strangle is the better choice. By choosing strikes further from the current market price, the trader increases the likelihood of the options expiring worthless, thereby maximizing the chances of retaining the entire premium collected.

Conclusion
The short-strangle strategy is an excellent strategy for traders who believe the market will stay within a specific range and want to capitalise on time decay. However, it’s essential to be aware of the unlimited risk potential if the market moves beyond the breakeven points. By carefully selecting strike prices and closely monitoring market conditions, traders can effectively manage the Short Strangle strategy to maximise their chances of success. As Sarvani has learned, each strategy comes with its own set of risks and rewards and understanding these is the key to making informed trading decisions. Success in options trading isn't just about picking the right strategy; it's about adapting to market conditions and aligning your strategy with your risk tolerance and market outlook.