Tips On Becoming An Options Trader; The Short Strangle
Financial markets and trading environments around the globe are places where certain unique terminology and phrases are used as part of the language of traders, and if you are an options trader, you will no doubt be familiar with a term used to describe a bearish bet on volatility, known as the short strangle.
If you are serious about trading financial markets, you might want to check out sites like http://moneymorning.com/tag/stocks-to-buy/ as a part of your routine, and it may well provide the inspiration for a short strangle trade.
The route to limited profit
A profit is a profit, however small, especially one where you use a strategy that helps you to limit the risk.
A short strangle is considered to be a bet constructed out of a bearish outlook and there is an accompanying trade called the short straddle, which is also used as a strategy aimed specifically at collecting premium.
It is basically a neutral strategy that is used in options trading, involving the simultaneous selling of what is termed as an out-of-the-money put, together with an out-of-the-money call involving the same underlying stock and expiry date for the trade.
Setting up a trade
A classic short strangle scenario is where you set up a trade which consists of two parts.
The first part of a short strangle involves a single short out-of-the-money call, followed by a short out-of-the-money put. You will often find that many traders using this tactic, will place this trade so that it only lasts for a brief duration, as this then limits the possibility of any potential volatility impacting the underlying transaction.
The short strangle will be just that, as it is almost always going to closed, or sometimes rolled out, if the underlying manages to reach either of the two strike parameters.
The basic premise behind a short strangle is that it is a strategy which offers fairly limited profit, and is placed when the trader believes that the underlying stock is unlikely to experience much in the way of volatility in the relatively short term.
A short strangle is probably best described as a credit spread, as net credit is taken when entering the trade in question.
Beware unlimited risk
It should be pointed out that despite the way the trade is constructed in order to gain a limited profit over a short space of time, there is still the very real possibility of large losses being incurred through a short strangle.
The way this occurs is when the underlying stock price surges in a direction against your bet, meaning that you end up facing a loss when the expiration date is reached and the bet is settled at the current price.
Traders might decide to place another short strangle or maybe a long strangle, which is deployed when a large movement is expected, as a way of trying to compensate their current losing position.
Understanding the advantages of a short strangle
If you are not yet familiar with the strategy, one of the best ways of gaining an understanding of what a short strange actually is and what advantages it offers, is to look at a typical example.
If you see a stock that is currently trading at $100 for instance, you might decide that with maybe some recent news already accounted for in the price, the stock might be in for a period of low volatility in terms of price movement.
If you believe that the time is right to employ a strangle option, you would then enter two option positions, the put and the call.
The two trading positions will aim to put you within the upper and lower reaches of the current $100 price, allowing for the spread margin. You will make a profit if the price of the stock subsequently moves outside of the range, if the call option expire with no gain and the put option has subsequently gained noticeably in value, cancelling out any losses incurred with the call option, leaving a net profit.
The situation works in reverse of course, so a strangle can see you make potential profits when the stock price rises or falls, provided you get in at the right price in the first place.
A long strangle has the potential to provide unlimited profit potential as it involves purchasing a call option, but what you are doing with a short strangle, is looking to take a profit from the net premium received, after allowing for any trading costs incurred.
Alisha Dyer works as an investment banker and writes for a variety of publications in her spare time as she discusses the latest stock exchange news along with tips for budding investors.