How to Make Money From Low Volatility
Last week, we looked at the long straddle and long strangle. Today, let’s take a look at how you can do a short straddle and short strangle.
As a memory refresher, a long straddle is when you simultaneously buy to open a call and a put with the same strike price and expiration on the same stock.
A long strangle is similar. The difference is that the call and the put will have different strike prices.
As you may have guessed, to open a short straddle and short strangle, instead of buying the call and put, you sell a call and put.
How a Short Straddle/Strangle Would Work
It’s important to understand that a short straddle or strangle is a bet against volatility.
Last week we used Athenex (NSDQ: ATNX) as an example. Let’s use it again to illustrate what would happen in short straddle/strangle scenario.
Using the real-world prices on February 18, for a short straddle you could sell a March 12.50 call for $2.95 and a March 12.50 put for $3. You will collect a $595 premium.
For a short strangle, you could sell the March 12.50 call for $2.95 and the March 10 put for $1.50. The total premium collected here is $445.
The chart below shows what your gain/loss would be if you held both legs to expiration.
Gain and Loss at Expiration
For the straddle, your perfect scenario would be if ATNX ends up exactly at $12.50 on the expiration date, March 19. If this happens, both the call and the put will expire worthless and your profit is $595.
But if ATNX ends at a different price, either the call or the put would be in the money. Whether you will end up profitable depends on how far away from $12.50 ATNX ends up at expiration.
Your breakeven points are $6.55 on the downside and $18.45 on the upside ($12.50 – $5.95, $12.50 + $5.90). As long as the stock price falls in between those two prices at expiration, you come out ahead.
If the stock is higher than $12.50 but lower than $18.45, the put will expire worthless and the $595 premium will more than cover your loss on the call. And if ATNX is lower than $12.50 but higher than $6.55, the call will expire worthless and your $595 premium will more than cover your loss on the put.
With a strangle, your total premium collected will be smaller, but you have a larger sweet spot where both the call and the put will expire worthless—between $10 and $12.50. In this range you realize your maximum profit of $445.
Your breakeven points are $5.55 ($10 – $4.45) on the downside and $16.95 ($12.50 + $4.45) on the upside.
As you can see from the examples, the less ATNX moves in either direction, the more profitable your trade will be. That’s why I said a reverse straddle/strangle is a bet against volatility.
Factors to Keep in Mind
For the purpose of the example, I ignored commission cost, which if you use a discount broker should be negligible (as in under $1 per contract). Also, keep in mind that in practice you don’t have to hold both positions to expiration. You can close either or both of the legs at any time prior to expiration so your actual gain/loss could end up quite different than indicated on the chart.
Note that the chart cuts off where the stock price is $30. However, there’s actually no limit to how high a stock can climb, so your potential loss on the upside is theoretically limitless.
The same is not true on the downside. A stock cannot fall to below zero, so your maximum potential loss is $655 for the straddle and $555 for the strangle. Beware, your risk exposure is far higher on the upside. To reduce risk, you can considered selling a covered call instead of a naked call.
If the shares of ATNX are put to you, you can decide to hold and see if the stock rises. If you are interested in doing this, it would make sense to use this short straddle/strangle strategy on a stock you wouldn’t mind buying at a discount.
Editor’s Note: Our colleague Scott Chan just described time-proven options strategies, but maybe options trading isn’t for you. There are other ways to beat the market.
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