Lesson 12: What are short straddles and short strangles?
Learn about short straddles and short strangles, how they differ and their associated risks.
CIBC Investor's Edge
A short straddle is a strategy involving the simultaneous sale of a call and put option with the same strike price and expiration date on an underlying stock or ETF. Both options are typically at-the-money.
A short strangle involves the simultaneous sale of a call and put option with different strike prices but the same expiration date on an underlying stock or ETF. The options are typically out-of-the-money with strike prices equally distant from the current stock price.
The goal is to close the short straddle or short strangle at a later date for a profit by correctly anticipating that little directional movement will occur in the underlying's price. In a profitable trade, the stock can move within a narrow trading range as long as it makes little directional progress. Both strategies benefit mainly from the time decay that occurs in the option premiums between trade initiation and closing of the position or until expiry, and from decreasing implied volatility.
When to use these strategies
These strategies are often used when you believe that a stock or ETF won’t make a significant directional move in the short term but will trade instead within a fairly narrow range.
Overall, the goal of both short straddles and short strangles is to profit from a decline in premium of the shorted options. The main gains in these strategies come through the passage of time and the resulting time premium decay; since the strategy contains two short options, the sensitivity to time decay is higher than for single-option positions. This decay helps to offset any losses from stock movement, as long as the stock move is not substantial.
Some traders initiate these positions when apprehension over an upcoming financial event has pushed implied volatility premiums higher. For example, an interest rate announcement or a stock-specific event such as an earnings announcement. Short straddle and strangle traders may look to take advantage of bloated premiums by selling both calls and puts. These strategies share some theoretical similarities with short selling a stock or ETF. In both situations, the trader believes the overpriced asset can be sold now and repurchased later at a lower price.
When considering either trade, factors to keep in mind include finding an underlying stock with the potential for little stock price movement until expiry and possibly decreasing implied volatility. A further-out expiration date will create a greater initial credit but leaves more time for the stock to experience a detrimental significant move in either direction.
How to place the trade
Trading short straddles or strangles involves opening the positions by selling a put and a call and receiving the premiums for both, a net credit position. The total amount received will depend on the value of the premiums and the number of contracts sold, less commissions. This is also your maximum potential profit.
To build a short straddle, select an underlying stock or ETF, choose an expiration date, and sell (sell to open) both a call and put with the same strike price, typically at-the-money. You can execute a short straddle as a multi-leg order or leg into it by opening one leg first and the other later. You’ll receive a net credit when you open the position, but your ultimate profit or loss won’t be known until you close the position or it expires.
To build a short strangle, select an underlying stock or ETF, choose an expiration date and select two separate out-of-the-money strike prices, one for the call and one for the put. The strike prices are typically approximately equal distances from the current stock price. Sell to open the selected call and put. You can execute a short strangle as a multi-leg order or leg into it by opening one leg first and the other later. You’ll receive a net credit to open the position, but your ultimate profit or loss won’t be known until you close the position or it expires.
Entering a short straddle or short strangle: Multi-leg strategy (MLS)
You can initiate a short straddle or a short strangle as a multi-leg trading strategy by specifying the net price you wish to receive, which will equal the combined value of the call and put. Both parts of the trade have to be filled at the same time, at the price you specify or better. If those conditions aren’t met, the trade won’t execute. In essence, it’s a form of contingent order — both parts get filled or neither do.
You may receive a partial fill on a short straddle or short strangle, but only in the ratio that you’ve specified. For example, if you’re selling 2 calls and 2 puts, you may be partially filled on 1 call and 1 put. Your fill will always reflect the specified ratio — in this example, 1 put for every 1 call.
Entering a short straddle or short strangle: Single-leg strategy
With this trade style, you place your order (sell to open) for the calls and puts as separate orders. This can be done consecutively, if you’re looking for an opportunity to secure a more advantageous price on one or the other side of the trade, or simultaneously.
This is also known as “legging in” to a strategy.
How do straddles and strangles differ?
Here’s a summary of the main differences between these trading strategies:
Same strike price for the call and put options
Different strike prices for the call and put options
Typically uses at-the-money options
Typically uses out-of-the-money options
More reactive to price changes in the underlying asset
Comparatively less reactive to price changes in the underlying asset
Typically generates higher credit when trade is placed
Typically generates lower credit when trade is placed
Either the shorted call or shorted put will typically have some value at expiry. This implies a lower theoretical probability that the trader will keep the entire initial credit and makes assignment more likely.
Both options may expire worthless. This implies a higher theoretical probability that the trader will keep the entire initial credit and makes assignment less likely.
Holds a larger percent of its value over time, assuming all else remains constant, a negative for the short straddle holder.
Holds a smaller percent of its value over time, assuming all else remains constant, a positive for the short strangle holder.
How do you make money from a short straddle or short strangle?
As mentioned, both positions benefit from time premium decay and minimal movement in the underlying stock price or contained movement within a narrow trading range. They also profit from a decrease in implied volatility, assuming other factors remain constant. As the expiration date approaches, time decay accelerates, causing both the call and the put options in the short straddle or short strangle to lose noticeable time value each day. This is a positive for both strategies. At expiration, the options will only be worth their intrinsic value.
To maximize profits, it’s important to decide whether to close the strategy before expiration or hold it until then. Closing the position before expiration helps to capture any profits but eliminates the possibility of benefiting from further time value decay. However, waiting too long may result in offsetting movements in the stock price and your profit may be reduced or disappear.
A directionally trending stock price, in either direction, and increasing implied volatility can negatively affect the value of a short straddle or short strangle. For the short straddle, the trade results in maximum profit when the underlying stock trades near or at the strike price at expiry. For the short strangle, maximum profit occurs when both options are out-of-the-money at expiration; that is, when the stock closes at a price between the two selected strike prices. For either strategy, you’ll be assigned if the call or put closes in-the-money at expiry. This is almost inevitable with one side of the short straddle and may or may not occur with the short strangle. The other option in the trade will expire worthless.
How to close a straddle or strangle
Closing the position can be done by buying back both the short call and put simultaneously, preferably at a lower total price than the initial credit received.
Alternatively, it’s possible to leg out by buying back one option first and the other option later. This approach can help manage liquidity concerns or adjust the strategy structure. It can also have a detrimental effect, as any intrinsic value gain on one side of the position, a negative for the seller, is no longer offset by a potential intrinsic value loss on the other side. This becomes a smaller consideration as expiry approaches, as there’s less time available for the stock to move and less time value decay to benefit from.
Holding the position until expiry
As mentioned, if your short call closes in-the-money at expiry, you’ll be assigned and obliged to sell the underlying stock at the strike price. If you don’t hold the stock, this will create a short position at the strike price, and you’ll face unlimited upside risk on that stock until you close that position.
If your short put closes in-the-money at expiry, you’ll be assigned and obliged to buy the underlying stock at the strike price. Since the stock price can’t fall below $0, your risk may be substantial, but the maximum risk is limited and can be calculated.
If either of these scenarios are not part of your trading plan, it may be prudent to close the entire short straddle or short strangle before expiry. Although the value of one side of the trade may be very low, unanticipated last minute stock movements on expiration day can quickly affect the profit/loss profile and profitability of a trade.
The short straddle can make money in a range between two breakeven points, and loses money if the stock closes below the downside breakeven point or above the upside breakeven point at expiration. The upside breakeven is equal to the chosen strike price plus the total premium paid. The downside breakeven is the chosen strike price minus the total premium paid.
The short strangle can make money in a range between two breakeven points, and loses money when the stock closes above the higher breakeven price or below the lower breakeven price at expiration. The upside breakeven is equal to the chosen call strike price plus the total premium paid. The downside breakeven is the chosen put strike price minus the total premium paid.
Risk of assignment before expiry
As American-style stock options can be exercised on any business day, short straddle and short strangle holders have no control over when they could be assigned. Both the short call and the short put or both can be assigned to you before expiry.
Short calls that are assigned early are generally assigned on the day before the ex-dividend date. Short puts that are assigned early are generally assigned on the ex-dividend date. If you want to avoid early assignment, you can close one side of the position and keep the other side or close the entire short straddle or strangle.
If early assignment of a stock option occurs, then stock is purchased if the short put is assigned or sold if the short call is assigned. If no offsetting stock position exists, then a new long or short stock position is created. If you don’t want to hold the stock position, you can close it by selling or buying, whichever is appropriate. Note that assignment of a short option might trigger a margin call if there isn’t sufficient account equity to support the stock position.
In addition to possible early assignment, explained in the previous section, corporate actions, such as stock splits, reverse stock splits, mergers, or acquisitions, can impact the underlying stock and subsequently affect the options held. These actions may cause changes to the option's structure, price, or deliverable. Be sure to stay informed about any corporate actions that may impact your positions. You can do this by regularly checking both your account holdings and any news on the stock.
Please remember that it’s your responsibility to verify that your holdings continue to reflect the objectives of your chosen trading strategies.