Profiting from Short Strangles – Part 1, the Basics

Peter D Submits:

 

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. 

 

1- The Basics

 

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.

 

 

2- Example Spread:

 

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:

 

 

Higher volatility will increase the value of the short PUT/CALL, resulting in a higher margin requirement. On the other hand, the short PUT and CALL would loose value over time, so the margin requirement does decrease with time.   

 

With 12 months CDs at 2.5%, a 27% annual return should make you want to trade options immediately. So, is there a catch?

 

Let’s see if a 20% downside cushion is sufficient. Going back 10 years, only a handful of times where SPY moved 20% or more per month, with three occurrences in 2008, September (close to 20%), October and November. With the SPY November panic low of $74.34 and the optimism around the new President, strike 70 PUT looks very solid. The probability of expiring below 70 is mathematically pegged at 5%. Note that we’ll reset the spread after 2/20/09, so we don’t care if SPY is below 70 after the February expiration. Possible adjustments are covered in the upcoming Part 2 of this article in case the strikes are breached.

 

On the upside, it would be fabulous for our 401k if SPY can get over 105 in six weeks. But the chance is remote, with a 10% probability of expiring above 105.

 

Finally, let’s go back in time to 7/11/2008 (also 6 weeks to August 2008 expiration) to see what profit a similar spread would give us when VIX is lower (27.49 versus the 42.82 currently). A Short Strangle of SPY 103 PUT/141 CALL would give us $0.31 credit, i.e. a maximum annualized profit of about 10% (SPY was $124 at that time). As I recalled the mindset at that time, we would have sold a tighter spread, such as 110 PUT/135 CALL for $1.11 (maximum 38% annualized), and would have been safe.

 

 

3- Margin Calculation Rules:

 

If you get lost in the margin calculation rules below, take 25% margin as a rule of thumb. The calculation usually results in a 10% to 30% margin requirement if you are sufficiently OTM (approximately 10% OTM).

 

Initial Margin – Short Uncovered PUT/CALL – The greatest of:                                         

                                               

                                               

Maintenance Margin – The greatest of:                                            

                                               

 

The margin requirement for a Short Strangle is the highest of either the PUT or CALL leg, plus the marked-to-market value of the other option.

 

These are relatively straight forward rules. The one obscure factor is that the value of the PUT or CALL could increase with the underlying stock movement or volatility, resulting in a much higher Maintenance Margin than the Initial Margin. Getting a Margin Call from your broker is the worst thing that can happen to a Short Strangle. It can be avoided with stops as described in section 2.

 

 

4- Legging in:

 

For more experienced traders, we might want to sell one leg of the spread first to increase the profit. We would sell the PUT first when there is a low, or sell the CALL first at a high. Doing it a few times a year can significantly increase your return.

 

Lastly, can we make more than 100% for each spread? Yes, if the combined value of the PUT and CALL is higher than the margin requirement.

 

 

Next, we’ll cover the possible adjustments in Part 2 of the article.