I really don’t like being naked short options as a rule. The prospect of potentially unlimited risk would keep me up at night. But then, you, dear readers, are not me. I am a risk adverse and conservative options trader, but that doesn’t mean that you have to be. Anyway, I’m an options educator now and not an advisor and as such see it as my responsibility to talk about all option strategies.
The short strangle is being short an out-of-the-money (OTM) call and an OTM put, each equidistant from the at the money option.
Your maximum profit is an expiration between strikes A and B and your risk, is well, unlimited. You probably want to sell the wings at least a one standard deviation move away. And index options are a better bet than stock options for two reasons:
- There is no risk of early exercise.
- Individual stocks are more prone to Event Risk, i.e., a takeover rumor or a bad earnings announcement.
Another good tool to use is the Measured Move Target as expressed by the at-the-money (ATM) straddle The ATM straddle shows where the market, in its supply and demand wisdom, believes the trading range will be.
Let’s look at the Russell 2000 (RUT), currently (March 24 10:00 CDT) trading at 1267, making the ATM straddle the 1265. The April 1265 straddle, expiring on April 17, is trading at 31.50. This implies a range in the RUT of 1233.50 and 1296.50 between now and expiration. This gives us our (MTM).
So, we can sell the 1300 call at 2.75 and the 1230 put at 6 for a total of 8.75, or $875 for each strangle sold.
If these RUT option expire with the Russell 2000 between 1230 and 1300, a 70 point range, you collect the whole “megillah.”
Of course, being naked short the options requires putting up a great deal of margin, as well as having potentially unlimited risk. Yes, 80% of OTM options regularly expire worthless. Yes, this strategy will probably work 10 out of 11 times, but it still seems to me to be akin to Russian Roulette.
But, hey, that’s me. I know people who swear by this strategy as a consistent income generator. If you have the stomach for the kind of risk that I do not, then this strategy might be for you.
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