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Options: The Strangle – Aptly Named Straddle Variation

A strangle is a variation on the straddle, and it presents some interesting possibilities in terms of profit potential and risk.

When you open a short strangle, you create positions in both a call and a put. The strikes are different but expiration and the underlying security are the same. A long strangle requires substantial movement in the underlying in either direction, to offset not only the initial cost but also time decay. A short strangle is a significant advantage in comparison. Time decay works for you, and the initial premium you receive for the two short positions cushions the potential loss if and when one side goes in the money.

In the ideal strangle, you ensure that both short options are out of the money. For example, the stock is at $42 per share. A short strangle consists of a 40 call and a 45 put; when you sell both, you receive premium.

The short strangle is going to have the greatest profit potential when volatility is higher than average - and the higher the volatility, the better. At such times, option premium is high, so shorting is going to be more likely to become profitable. This condition tends to be short-term, so when volatility returns to normal levels, one or both sides of the short strangle can be closed for a profit. So the strangle can be viewed as a volatility play, opened when premium is rich and then closed as soon as possible when volatility falls and the option values follow suit. It can also be treated as a strategy you hold until expiration or close to it; in this strategy, you want the stock price to remain in between both strikes, so that both options stay out of the money. If one side goes in the money, the position can be closed or rolled forward.

A strangle requires the different strikes, compared to the standard straddle in which the strikes are the same. In the short straddle, any movement away from the strike puts one side or the other in the money. So to avoid exercise through rolling, a straddle writer may convert to a strangle by replacing the short call with a later-expiring, higher-strike call, or a later-expiring, lower-strike put. With the strangle, it is easier to avoid exercise by being prepared to close one side of the position when stock price approaches the money.

While some observers criticize both short straddles and short strangles as high-risk, the problem is not always that extreme. For example, if you own 100 shares of the underlying, the call side of the strangle is covered, vastly reducing risk. Remember, look for high volatility and be prepared to close at a profit in the short-term change. It is better to take a small profit now than risk exercise later. Also keep an eye on the status of stock price versus strikes and be prepared to close or roll.

The ideal timing for a short strangle is when the underlying is trading in consolidation. As long as the price remains range-bound, selecting strikes at or near resistance and support adds safety to the overall position. As signals emerge of a likely breakout from consolidation, one side or the other can be closed or rolled.

For anyone owning shares and covering the short call side of the strangle, avoid ex-dividend month expirations. The period immediately before ex-dividend is the most likely timing for early exercise.

Michael Thomsett blogs at blogs at Options Money Maker, the Top Advisor's Corner at Stockcharts.com and Seeking Alpha and several other websites. He has been trading options for 35 years and has published books with Palgrave Macmillan, Wiley, FT Press and Amacom, among others. His latest book is Making Money with Option Strategies