Construction: Short one call and short one put with different strike prices but the same expiration date. Both options are usually out-of-the-money. Because both options are sold, the strategy results in a credit.
Function: To take advantage of a stock entering a stagnant or low volatility trading range.
When to Use: Normally around a time away from expected news releases (i.e. earnings, FDA announcements, etc.) when you feel that the lack of news can lead to a period of stagnation. Also, good to use when you feel implied volatility is likely to decrease sharply.
Breakeven: The breakeven points for the Short Strangle are the same as the Long Strangle. For the upper breakeven point, take the credit amount received and add it to the call strike. For the lower, subtract the credit from the put strike.
Max Gain: Profits are realized if the stock price stays between the breakeven points at expiration. The maximum gain is the initial credit, and is realized for all stock prices between the call and put strikes.
Max Loss: Losses occur for all stock prices outside of the breakeven points. Because there’s no upper limit on how high a stock price can rise, losses are unlimited to the upside. The max loss to the downside is the put strike minus the credit received (the breakeven price). Key Concepts – the passage of time benefits the strategy. The longer the stock remains stagnant or between the two break-even points, the better. Decreasing implied volatility also benefits the strategy.
Example: With the stock at $52.50, sell one March $50 put for $1, sell one March $55 call for $1.20. The total credit is $2.20 and is also the most you can make. The maximum gain occurs for all stock prices between the $50 and $55 strikes.The upper breakeven is the $55 call strike plus the $2.20 cost, or $57.20. The lower breakeven is the $50 put strike minus the $2.20 cost, or $47.80. Losses are realized for all stock prices below $47.80 or above $57.20 at expiration. Because there’s no limit on how high a stock price can rise, there’s no upper bound on the losses that can occur as the stock price rises beyond $57.20. The maximum loss is the put strike minus the initial credit received (breakeven price). If the stock price fell to zero, you’d be assigned on the $50 put, but because you received $2.20 to initiate the position, your maximum loss would be $47.80.