How to make Profit in a Sideways Market: Short Strangle strategy

How to make Profit in a Sideways Market: Short Strangle strategy

A Short Strangle strategy consists of one short call with higher strike price and one short put with lower strike price. It is established for a net credit and generates profit only when the underlying stock expires between two strikes sold. Every day that passes without large movement in the underlying assets will benefit this strategy due to time erosion. Volatility is a vital factor and it can adversely affect a trader’s profits in case it goes up.

When to initiate a Short Strangle strategy?

A Short Strangle strategy should only be used when you are very confident that the security won’t move in either direction because the potential loss can be substantial if that happens. This strategy can also be used by advanced traders when the implied volatility goes abnormally high and the call and put premiums may be overvalued. After initiating Short Strangle, the idea is to wait for implied volatility to drop and close the position at a profit. Inversely, this strategy can lead to losses in case the implied volatility rises even if the stock price remains at same level.

How to construct a Short Strangle strategy?

A Short Strangle strategy is implemented by selling Out-the-Money Call option and simultaneously selling Out-the-Money Put option of the same underlying security with the same expiry. Strike price can be customized as per convenience of the trader but the call and put strikes must be equidistant from the spot price.

Let’s try to understand with an example:

Suppose Nifty is trading at 8800. An investor, Mr A is expecting very little movement in the market, so he enters a Short Strangle by selling 9000 call strike at Rs 40 and 8800 put for Rs 30. The net upfront premium received to initiate this trade is Rs 70, which is also the maximum possible reward. Since this strategy is initiated with a view of no movement in the underlying security, the loss can be substantial when there is significant movement in the underlying security. The maximum profit will be limited to the upfront premium received, which is around Rs 5250 (70*75) in the example cited above. Another way by which this strategy can be profitable is when the implied volatility falls.

For the ease of understanding, we did not take into account commission charges. Following is the payoff chart and payoff schedule assuming different scenarios of expiry.

The Payoff Chart:

The Payoff Schedule:

Impact of option Greeks:

Delta: A Short Strangle has near-zero delta. Delta estimates how much an option price will change as the stock price changes. When the stock price trades between the upper and lower wings of Short Strangle, call Delta will drop towards zero and put Delta will rise towards zero as the expiration date draws nearer.

Vega: A Short Strangle has a negative Vega. This means all other things remain the same, increase in implied volatility will have a negative impact.

Theta: With the passage of time, all other things remain same, Theta will have a positive impact on the strategy, because option premium will erode as the expiration dates draws nearer.

Gamma: Gamma estimates how much the Delta of a position changes as the stock prices changes. Gamma of the Short Strangle position will be negative as we are short on options and any major movement on either side will affect the profitability of the strategy.

How to manage risk?

Since this strategy is exposed to unlimited risk, it is advisable not to carry overnight positions. Also, one should always strictly adhere to Stop Loss in order to restrict losses.

Analysis of Short Strangle strategy:

A Short Strangle strategy is the combination of short call and short put and it mainly profits from Theta i.e. time decay factor if the price of the security remains relatively stable. This strategy is not recommended for amateur/beginner traders, because the potential losses can be substantial and it requires advanced knowledge of trading.