Profiting from Short Strangles - Part 1, the Basics

 

The Short Strangle strategy becomes more attractive with the volatility remaining at historically high level. Part 1 of this article describes the strategy basics, including the complex margin requirement that changes with the underlying stock movement. We’ll deal with the Short Strangle adjustments, as well as how to use Short Strangle if you are an active trader in subsequent parts of the article. If you have been investing in Money Market or Certificate Deposits, then this is the perfect strategy to at least triple your return with manageable risks. 

 

From PowerOpt.com (http://www.poweropt.com/shortstranglehelp.asp):

 

The Short Strangle is a neutral position. The investor will profit from the position if the stock stays stagnant and expires within the profitable range.

 

- Sell (short) out-of-the-money (OTM) CALL(s) in a selected target month.

- Sell (short) the same number of out-of-the-money (OTM) PUT(s) for the same month.

- The maximum profit is the net credit (total premiums received).

- The maximum risk is infinite in either direction (infinite to 0 on the put side/decline).

- The position has both an upper break even and a lower break even.

- Profit is realized if the stock price remains between the upper and lower break even points.

 

 

 

Since the maximum risk is infinite in either direction, the most critical factor is to select the underlying stock that doesn’t go to zero or infinite in a hurry. The best hedge is to use a basket of stocks using ETFs. The favorites are SPY, DIA, QQQQ, and IWM.

 

Note that margin is not usually allowed retirement accounts, so selling Short Strangle would not work well for retirement accounts.

 

Let’s look at a practical “Strangle a Spy” example (thanks to GabbyH, the 85 years old PSW member for the catchy phrase) for prices at the close of 1/9/2009: