(While on vacation until Oct 26th, I’m going to be sharing some anecdotes on my favorite trading strategies: why I use them, when, and how I manage them once they are on.)
The majority of trades we do here with All Star Options tend to be directional in nature. And why not? We’re leveraging best-in-class technical analysis to give us an uncommon edge to participate in emerging and/or continuing trends. And if we know anything as Traders, we know that if we have an edge, we should attempt to execute against that edge as often as possible.
Meanwhile, I recognize there is an entire cottage industry around “selling options premium” and for good reason — it works! That doesn’t mean it always works nor does it mean it’s easy. I just don’t like to make it my only thing.
That said, one of my favorite strategies is to sell premium via Short Strangles.
A Short Strangle is a delta-neutral options spread that consists of two legs: a naked short put position and an equally-sized naked short call position. Both option strikes are typically out-of-the-money. Here’s how a typical PnL graph for a Short Strangle would look:
It should be noted that due to the naked options, this type of spread will require margin and we have theoretically unlimited risk if the underlying were to take off in either direction on us.
The first order of business when putting these spreads on is to seek out instruments — preferably ETFs or large cap stocks — that are experiencing elevated implied volatility (IV). When IV is high, options premiums are elevated because market participants are bidding up the cost of calls and puts either to hedge some perceived risk or to take advantage of a speculative opportunity. Now, there is no precise IV value I look for. I just want the IV for the stock today to be in the upper end of the range of where its been over the past 6-12 months. High premiums offer us an edge as volatility tends to mean revert and when that happens, the high volatility options we sold at higher prices tend to see their value erode (a great thing when we’re short!)
When I’ve selected the right instrument, my initial instinct is then to identify the 25 delta strikes for both the calls and puts. But that isn’t always the strikes I end up selecting. More important to me is that the strikes line up just beyond obvious levels of support and resistance.
For instance, here’s a recent Short Strangle trade I put on in $XLI October options:
The horizontal lines represent the short call (107) and short put (98) strikes I had chosen. Notice how those strikes corresponded nicely with overhead resistance and downside support? It just so happened that both of these options were each sporting approximately 25 deltas. It’s amazing how often that ends up being the case. (Market makers are no dummies!)
My profit goal with Short Strangles is always to keep 50% of the original premium collected. Let’s say I collected a $3.00 credit for the spread on Day 1. Once I can buy-to-close the spread back for a $1.50 debit or less, I’ll do so, booking my profits and moving on to the next trade. When I put this $XLI trade on above, it had approximately 6 weeks until October expiration. But it only took me two weeks to cover this spread at my profit target of 50% of the original premium collected in the trade.
Why do I cover at 50%?
Because once the spread loses value (a good thing when we’re short it), we start getting to a point of diminishing returns. Let’s say that spread I sold for $3.00 is now only worth 75 cents. I’ve got a winner on my hands and that’s nice. But now I can only make 75 cents more if I hold all the way to expiration and the options expire worthless — but I’m still holding the entirety of the theoretically unlimited risk! That math doesn’t make sense. It doesn’t make sense to get paid so little to hold so much risk. So I’d rather just cut the trade loose once I’ve earned 50% of the original credit and then move on to new opportunities with less risk.
On the risk management side, I know a lot of people who trade Short Strangles like to move strikes on the winning side to bring in more credits to defend a losing position and that’s fine if you want to put in that kinda work. But for me, I chose my short strikes for a reason (because they were significant support & resistance levels), and therefore I’m going to hold the trade and trust its going to work as long as the stock or ETF stays inside those strikes. But if the underlying moves outside those strikes, why defend it? Clearly my reason for being in the trade (a stubborn range) has been violated and therefore my thesis is busted. I’m not going to defend this trade and argue with the market. No, I’m just going to close the trade, book the loss, and move on. Let it be somebody else’s problem.
I always try to have some strangles working in my portfolio most of the time. They are a good counterbalance to a portfolio of mostly directional trades. When markets start grinding sideways and breakouts are failing left and right, it’s nice to have some delta neutral trades like Short Strangles on the books that profit during sideways churns and offer some profits much needed profits.
Do you trade Short Strangles? If not, why not? I’d love to hear from you.