Possible adjustments for short strangles, including passive adjustments at expiration and active adjustments prior to expiration, are examined in this section. Let’s also re-iterate the practical “Strangle a Spy” example from Part 1 to provide additional clarity to the concepts:
– For prices at the close of 1/9/2009, Sell SPY Feb 70 PUT (20% downside cushion with SPY at $89) and Sell SPY Feb 105 CALL (17% upside cushion) for $0.81 credit.
– The margin requirement was $8.9 ATM (At-The-Money), $24.2 for SPY at $105, or $18.4 if SPY drops to $70.
1- Passive Adjustments at Expiration
a) No adjustment: If SPY closes between the two short strikes, e.g. $70 and $105 on 2/20/2009, both the short PUT and short CALL expired worthless, the maximum profit is realized, and no adjustment is needed.
b) Rolling “horizontally”: If SPY closes below the PUT strike, the short PUT can be rolled horizontally to the same strike next month for a credit. We are betting that the market will eventually recover to above the short PUT strike so that we keep the premium of all short PUT sold. We can keep rolling horizontally very month as premium sellers. However, the margin requirement does increase when the stock goes lower due to the increased PUT value. Prudent money management to absorb the margin requirement is a must when using Short Strangle strategy.
Let’s look at December 2008 expiration example to see how much credit we would get when rolling horizontally. Since the stock price would be below the short PUT strike, we would look at ITM rolling to simulate the possible credit.
SPY closed at $88.19 on 12/19/2008, rolling:
– Dec 89 PUT to Jan’09 89 gives $3.60 credit (short PUT is 1% ITM)
– Dec 91 PUT to Jan’09 91 gives $2.58 credit (3% ITM)
– Dec 94 PUT to Jan’09 94 gives $1.50 credit (7% ITM)
– Dec 97 PUT to Jan’09 97 gives $0.78 credit (10% ITM)
The amount of credit is also dependent upon the volatility reading at the time. Note that all these rolling of the PUT and selling of additional short CALL would give more credit than the $0.81 credit from the original Short Strangle. This means the profit potential is much greater if the market recovers to higher than the original short PUT strike in the coming months.
c) Rolling diagonally towards ATM: For catching up with the downward or upward movement, the short PUT or CALL can be rolled diagonally to catch up with the market. The number of strikes that can be rolled for a credit depends upon how much ITM the short PUT or CALL is. The more ITM, the less number of strikes that can be caught up.
Looking at December 2008 expiration example again, rolling:
– Dec 89 PUT to Jan’09 84 gives $1.66 credit (PUT is 1% ITM, rolling down five $1 strikes per month)
– Dec 91 PUT to Jan’09 88 gives $1.11 credit (3% ITM, catching up three $1 strikes)
– Dec 94 PUT to Jan’09 92 gives $0.25 credit (7% ITM, two $1 strikes)
– Dec 97 PUT to Jan’09 96 gives $0.03 debit (10% ITM, one $1 strike)
Clearly, if the short PUT is just ITM, we can easily catch up with the market and rolling down a few strikes a month. This is a powerful strategy as we can catch up with a 25-40% market drop per year. However, for 7% or more ITM, it is much harder to catch up. A simple trick is to roll horizontally to the same strike next month and upon any bounce, roll down a few strikes immediately when it is cheaper to roll.
2 – Active Adjustments prior to Expiration
a) Stop and go: For sudden market movement in either direction, the short PUT or short CALL can be stopped out and resold at the same strike for more credit. This is useful for swing traders who can optimize profit by getting more credit than the original short strangle.
A variation is to sell at strikes further away from ATM for the same price that it was stopped out to further reduce risk.
b) Vertical rolling away from ATM: When the stock moves closer to the short PUT strike, we can roll the short CALL to a lower strike for a credit, which is used to move the short PUT down (away from ATM) to decrease the exposure risk. Since the PUT is closer to ATM, the number of strikes that we can move the PUT is less than the number of strikes that was given up from the CALL. Although we have effectively reduced the spread between the PUT and CALL, it may still be acceptable as there is less time to expiration, i.e. less chance to reach the short CALL strike, than when the original short strangle was sold.
The reversed adjustment is applicable to the short CALL leg, i.e. selling higher PUT and using the credit to roll the short CALL higher.
c) Take the profit and run: If the spread, or either strike is profitable prior to expiration, we can buy back the PUT, CALL or both for a profit, then sell the next month short strangles. With options, it is difficult to squeeze out the last 25% of the premium, so it is a good practice to buy back the spread with 75% profit prior to expiration. This minimizes the risk of loss if there is extreme market movement close to expiration.
