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What are the breakeven points for the Short Strangle Option ?
Break even points are the points or spots when there is no profit - no loss for the option trader. i.e. they are the points either side of which there is a profit area and a loss area.
Upper Breakeven Point of Short Strangle Option = Strike Price of Short Call + Net Premium Received
i.e. $60 + $8 = $68
Lower Breakeven Point of Short Strangle Option = Strike Price of Short Put - Net Premium Received
i.e. $40 - $8 = $32
What is the maximum profit for Short Strangle Option Trading Position?
The profit from Short Strangle is LIMITED or capped. Its a very risky option combination to trade.
As we can see from the final net payoff function PINK colored graph for the Short Strangle Option, the maximum profit appears as a flat region between the 2 strike prices of the OTM call & Put strike prices. Maximum profit comes only when the underlying stock price ends between the Put strike and call strike on the expiry date. In that region, none of the short options (call or put) gets exercised and the Short Strangle Options trader gets to keep the entire option premium as profit ($8 in this case minus the Option Brokerage)
In case the underlying price does not end in the region between the 2 strikes but slightly away, then the profits start declining linearly.
Maximum Profit for Short Strangle = Net Option Premium Received - Option Brokerage Commissions
Profit from Short Strangle will be achieved only when Price of the Underlying stock remain in a range - higher than the Lower breakeven point and lower than the Upper breakeven point
But please note that the option traders must also account for the option brokerage which they pay for entering into & exiting from the Short Strangle positions. You will short 2 options to enter the Short Strangle, and 2 trades to exit the Short Strangle (or at least one of them will get exercised). Hence, those brokerage and commissions should also be deducted to get an exact amount of profit value.
What is the maximum loss for Short Strangle Option Trading?
Theoretically, the maximum loss you can suffer on this Short Strangle Option Position is UNLIMITED. Hence, only experienced options traders are advised to try the Short Strangle Trade. Remember, you are taking a bet on sides. If the stock price makes a big move in either upward or downward direction, you will take a very big loss. There are 2 possibilities working against you (big move in either direction) and only one in your favor (no big move).
Irrespective of your level of expertise in options trading, you MUST keep strict stop loss both on option prices as well as on the underlying price movements.
Maximum loss of Short Strangle Option = Price of Underlying - Strike Price of Short Call - Net Options Premium Received + Option Trading Brokerage (at exit or exercise)
OR
Maximum loss of Short Strangle Option = Strike Price of Short Put - Price of Underlying - Net Options Premium Received + Option Trading Brokerage (at exit or exercise)
Even a 1 point move either way of strike prices will trigger one of the options to be exercised which might incur more brokerage charges (depending upon your broker).
What are the risks in trading Short Strangle Option ?
Short Strangle is considered to be one of the riskiest trading strategy in the options trading - it advised that novice traders should stay away from trading this combination as you may loose much more than you can earn. It should be traded only by experienced options traders that too with strict stop loss with a constant monitoring. Remember, in Short Strangle, you can loose much more than the limited profit potential you are targeting for.
- Bid-Ask Spread will impact your trade strategy and calculations - while shorting, you may not receive the correct price and while squaring off you may again not get the correct price. Option prices vary with big magnitudes due to lack of proper pricing mechanism.
- Constant monitoring of price of both the underlying as well as (call & put options) is required. The options pricing still goes weird at times which means you are at a risk.
- Time decay will benefit this Short Strangle position. Hence it is advisable to enter this position with a maximum of 1 month to expiry since time decay rate is highest in the last month. (See Options Time Decay: Explained with Examples).
- Increase in Volatility will be a problem for this trade - high volatility will increase the option prices causing loss to the short strangle trader. It will also increase the possibility of big moves in either direction for the underlying stock price.
- Note that this is a double Short position - which means the option trader will need to keep high amount of margin money with his broker for both the short positions
- Avoid taking Short Strangle positions on index options - stocks can still be better forecasted for stability in price movements, but indices are constituted by multiple stocks and they may make big moves because of few heavyweights leading to more probability of losses.
- Above all, Remember this is a very HIGH RISK strategy - you may loose much more than what you potentially can receive in profit
Let's now head on to next part Tips to Enter & Exit Short Strangle Options Trading Position
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