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Collect Maximum Income Selling Straddles and Strangles

Tony Zhang
July 8, 2021
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11 minutes read
Collect Maximum Income Selling Straddles and Strangles

Straddles and strangles are considered advanced options strategies that are suitable for more experienced traders with a high tolerance for risk. However, they also generate maximum income for investors with larger accounts and longer investment horizons. Both of these strategies require a sizable margin account and clearance to trade Level 4 or Level 5 options (depending on the brokerage). Straddles and strangles represent unlimited risk and require that investors take short naked call and put positions, which may not be suitable for many investors. In this post, we will explore how the higher level of risk in these strategies can be offset by the trade’s maximum income potential. 

Short Straddles

Selling a straddle involves selling a call and a put with the same expiration date and the same strike price. This results in a neutral position where the premium collected acts as the buffer against the stock’s movement. As long as the stock stays within the range defined by the strike price plus or minus the premium, the strategy will be profitable. However, there is no limit as to how far the stock can drift from the strike price, such that the strategy carries unlimited risk. This trade remains profitable as long as the stock stays within the range bound by the breakeven prices. Straddles provide an advantage over selling a naked call or put by allowing for an adverse move in both directions. Additionally, with almost double the premium or income of a naked call or put, a straddle provides a much larger buffer before the investor will sustain losses.  

Example:

WEED is currently trading at $27.71 (May 24, 2021)

  •       Sell a 2-month $28 call @$2.80
  •       Sell a 2-month $28 put @ $3.10
  •       Collect a total credit of $5.90
  •       Max reward = $5.90
  •       Max risk = unlimited
  •       Breakevens at $22.10 and $33.90

Chart: Short Straddle

Source: OptionsPlay

Selling this straddle on WEED allows an investor to be profitable within a wide range of prices for WEED. The stock can move within a range of 21% higher or lower than the strike and the straddle will remain profitable. While the strategy does come with unlimited risk, even if the stock were to rally 42% (double the premium collected), the risk will be $5.90, or 100% of the premium collected.

Short Strangles

Short strangles are almost identical to short straddles. However, they require selling an out-of-the-money call and a put with the same expiration date but a different strike price. The investor collects less of a premium than with a straddle, but the breakeven prices are further apart. 

Example:

WEED is currently trading at $27.71 (May 24, 2021)

  •       Sell a 2-month $30 call @$2.05
  •       Sell a 2-month $25 put @ $1.45
  •       Collect a total credit of $3.50 
  •       Max reward = $3.50
  •       Max risk = unlimited
  •       Breakevens at $21.50 and $33.50

Chart: Short Strangle

Source: OptionsPlay

 

Much like straddles, strangles remain profitable as long as the stock stays within the range bound by the breakeven prices. It starts to lose money if the strike price moves out of the breakeven range. In this example with WEED, the strangle allows the stock to remain profitable trading in a 22% range higher or lower. While the strategy is profitable in a wider range, strangles can more quickly produce larger losses due to the lower income collected upfront. A 33% rally in WEED would result in a loss that is equal to the premium collected. 

Option Greeks

Straddles and strangles are unique in their characteristics and require a good understanding of option Greeks in order to make the most of these strategies.

Short Straddles & Strangles
  •       Short vega (volatility). When selling an option, the trader is short volatility (declining volatility works in the trader’s favour). In the case of a straddle, the investor’s exposure to vega is doubled because two options are shorted. 
  •       Short theta (time decay). Time decay works in the option seller’s favour. Like vega, straddles are exposed to double the time decay of a naked call or put. The option’s price will decline over time, and the trader can buy the option back to close the position at a lower price.
  •       Delta is neutral initially, but will drift as the stock rises or falls. Assuming that the call option has a delta of -50 and that the put option has a delta of +50, the legs offset each other, resulting in a trade with a net delta of 0. However, as the stock drifts further away from the strike price, the delta exposure that is gained cancels out the benefits of theta and vega working in the trader’s favour. 
  •       Short gamma (sensitivity to delta). As the stock drifts from the strike prices that were sold, with a short gamma exposure, a short straddle and strangle will move towards a delta of -1 in either direction.

Maximizing Straddles and Strangles

In order to maximize income from straddles and strangles, the investor needs to understand the 4 Greeks mentioned above and implement these strategies when they can be maximized. To maximize vega, both strategies will perform best when traded with implied volatilities that are high. Additionally, market timing on direction plays a huge role in the success of these strategies. While many investors believe that the ideal time to sell a straddle/strangle is once a trading range has been established, our research shows just the opposite: stocks tend to consolidate into a range after a large, outsized move. And after a stock exhibits outsized moves, this also tends to coincide with elevated implied volatility, an ideal condition for selling a straddle.

An example of this is the period after SHOP declined 25% within a 7-day period, from Sept. 1 to Sept. 8, 2020, and the implied volatility jumped from 53% to over 68%. Over the following 3 weeks, as the stock stayed around the $1,220 level, the implied volatility dropped from 68% back to 54%. This is an example where an investor who sold a straddle or a strangle after the 25% drop would find that vega, theta, delta, and gamma were all working in favour of the short straddle, maximizing the income on the trade. 

Chart: SHOP Price & Implied Volatility

Source: iVolatility & TradingView

 

Straddles and strangles are complex options strategies that are better suited to experienced traders with a higher risk tolerance. In addition, this strategy requires a longer investment horizon over a large number of trades. The success of both strategies is rooted in the ability to sell them consistently for the income they provide, to offset the losses from big moves in the underlying stock or ETF. While strangles may provide a larger range between the breakeven prices than straddles, the trade-off is a larger percentage loss on the strangle if the stock rallies or declines significantly. Both strategies are unforgiving, with unlimited losses if they are not managed correctly, or if the underlying makes a significant move in either direction. However, the upside is the sizable income they can provide compared to selling naked calls and puts when vega and delta can be maximized under the right conditions. 

Take advantage of free access to OptionsPlay Canada: www.optionsplay.com/tmx 

 

Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

Copyright © 2021 Bourse de Montreal Inc. All rights reserved. Do not copy, distribute, sell or modify this document without Bourse de Montreal Inc.’s prior written consent.  This information is provided for information purposes only. The views, opinions and advice provided in this article reflect those of the individual author. This article is not endorsed by TMX Group or its affiliated companies.  Neither TMX Group Limited nor any of its affiliated companies guarantees the completeness of the information contained in this article, and we are not responsible for any errors or omissions in or your use of, or reliance on, the information.  This article is not intended to provide legal, accounting, tax, investment, financial or other advice and should not be relied upon for such advice.  The information provided is not an invitation to purchase securities listed on Toronto Stock Exchange, TSX Venture Exchange and/or Montreal Exchange.  TMX Group and its affiliated companies do not endorse or recommend any securities referenced in this publication.  Toronto Stock Exchange, TSX, TMX, the TMX design, The Future is Yours to See., and Voir le futur. Réaliser l’avenir. are the trademarks of TSX Inc. and are used under license.  Montreal Exchange and MX are the trademarks of Bourse de Montréal Inc.  All other trademarks used herein are the property of their respective owners.

Tony Zhang
Tony Zhang http://tmx.optionsplay.com

Head of Product Strategy for OptionsPlay

OptionsPlay

Tony Zhang is a specialist in the financial services industry with over a decade of experience spanning product development, research and market strategist roles across equities, foreign exchange and derivatives. As the current Head of Product Strategy for OptionsPlay, Tony leads the research and development of their OptionsPlay Ideas & Portfolio platform. He has leveraged his interest in financial technology and product development to provide innovative, reimagined solutions to clients and the users they seek to serve. Previously he spent 7 years at FOREX.com with a capital markets and research background as a market strategist specializing in equity and FX derivatives markets.

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