Short Strangle
Risk: high
Reward: limited
General Description
Entering a short strangle entails selling out-of-the-money calls and puts.
The Thinking
You are not bullish or bearish and you feel fairly certain the stock will not move much from its current position. You sell calls and puts (essentially you are using a naked call and naked put position at the same time) and will keep most of the premium as long as the underlying issue trades sideways. But if the stock takes off in either direction your risk is huge because you have no protection.
Example
Let's say OMC is trading @ 65, and you sell the 70 calls for 2.4 and sell the 60 puts for 2.6 for a total credit of 5.0. If the stock closes anywhere between 60 and 70, both legs of the strangle will expire worthless and you keep the premium collected from both. But if the stock closes below 55 (calls expires worthless and naked put incurs a loss) or above 75 (puts expire worthless but naked call incurs a loss) you will lose money and your loss gets grows for every tick beyond the 55-75 range the stock moves.
The image below summarizes the trade with a P/L Diagram. |
