There are plenty of ways to profit on a stock's movement, beyond investing in the actual stock itself. Options provide a nearly endless array of strategies, due to the countless ways you can combine buying and selling call option(s) and put option(s) at different strike prices and expirations.
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A call is an options contract that gives the owner the right to purchase the underlying security at the specified strike price at any point up until expiration. A put is an options contract that gives the owner the right to sell the underlying asset at the specified strike price at any point up until expiration.
A short strangle is a neutral strategy that profits if the underlying asset remains within a specified trading range through expiration. Selling a short strangle is the opposite of a long strangle.
The basic setup
To implement a short strangle, you would simultaneously sell an out-of-the-money put along with an out-of-the-money call. A short strangle trader believes that the stock will not exhibit volatility in the near term and will hopefully remain range-bound through expiration. You would sell a put with a strike price below the current price, while selling a call with a strike price above the current price. The goal is for the stock to stay in between the strike prices, in which case both options expire worthless.
For example, if a stock is trading at $50, and you expect the price to stay between $45 and $55, you could simultaneously sell a $55 call and a $45 put. Let's say that the call and put are both trading at $1.50 (both should have comparable pricing due to put/call parity). The net credit for this trade would be $3.
Maximum loss: unlimited
A short strangle has theoretically unlimited risk, primarily due to the fact that the short call is naked, since a naked call also has a theoretically unlimited maximum loss as well. There is no upper-bound limit to a stock's price, and you may be forced to deliver shares at the short call strike price. It goes without saying that this risk is hypothetical since stock prices do not actually increase to infinity. The short put part of the strategy has a maximum possible loss of the put strike price minus the premium received.
In this example, if the stock skyrocketed to $100 for some reason, you would have to purchase shares at $100 and deliver them at $55. The $45 in losses would be partially offset by the $3 in premium received upfront, netting out to $42 in losses. But what if the stock were somehow acquired for $150? Conversely, if the company were to go bankrupt and the stock declined to $0, you would be required to purchase shares at $45 due to the short puts, but the shares would be worth $0, and the $45 in losses in this scenario would similarly be partially offset by the $3 in premium received upfront, netting out to $42 in losses.
Maximum gain: net credit
The most that you can make on a short strangle is the net credit in premium received upfront. This occurs if the stock stays within the strike prices through the expiration date, and all options expire worthless.
In this example, if the stock were to stay between $45 and $55, then all contracts would expire worthless and you would keep the $3 received.
Breakeven: call strike price plus premium received or put strike price minus premium received
There are two breakeven points for a short strangle, depending on which way the stock goes. If the stock begins to rise, the upper breakeven point is the call strike price plus the premium received. If the stock begins to decline, the lower breakeven point is the put strike price minus the premium received.
In this example, the upper breakeven point would be $58 and the lower breakeven point would be $42. Any price above $58 or below $42 would generate losses.
The article What Is a Short Strangle? originally appeared on Fool.com.
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