The Ultimate Guide To Trading The Strangle (Safely & Profitably)

The Short Strangle is by far the most consistent income-generating Options strategy.

It is one of the bread-and-butter strategies that I use regularly.

And it is the reason why I can be consistently profitable trading Options.

However, the thought of trading the Short Strangle is very scary to many people.

That is because it involves not just one but two naked Options – a Short Put and a Short Call.

And when many new traders hear the word “naked”, they get intimidated because it can mean “unlimited” losses.

While that is theoretically true, in a practical sense however, that doesn’t really happen.

But, you can certainly still potentially lose a lot of money if you don’t know what you’re doing.

So how do you trade the Short Strangle?

And more importantly, how do you trade it safely and profitably?

Buckle up your seat belt because I’m going to share with you everything you need to know to trade the Short Strangle like a pro.

What Exactly Is the Short Strangle

The Short Strangle is a neutral undefined risk Options strategy that seeks to profit if the market stays in a given range.

It consists of two single Options:

• Short Put
• Short Call

Both the Short Put and the Short Call are always Out-of-the-Money (OTM).

If the market stays within the Short Put and Short Call by expiration, you will make the full premium that you sold the Short Strangle for.

If you’re slightly bullish on the market, you can construct a Bullish Strangle instead of a neutral one like this:

And if you’re slightly bearish on the market, you can construct a bearish strangle like this:

Why Trade The Short Strangle?

There are three main reasons to trade the Short Strangle.

Reason #1: Pure Theta (Time Decay)

Because you have two Short Options, you have maximum Theta (aka Time Decay) working for you.

If you’re not familiar with what Theta is, it simply means the devaluing of Options over time.

The value of an Option primarily consists of two things:

• Intrinsic Value
• Extrinsic Value (aka Time Value)

These two values make up what we call the “premium” of an Option.

In-the-Money (ITM) Options have both Intrinsic and Extrinsic Value.

Whereas OTM Options only have Extrinsic Value.

So when we’re trading the Short Strangle, we are selling Extrinsic Value.

In order for us to profit from this strategy, we need to close out the trade for less than what we sold it for.

For example, if we sold a Short Strangle for $3.00, we need to close the trade for less than this amount to be profitable.

So if we close out the trade for $1.00, it means we made $2.00 on the trade (which equals to $200 per Short Strangle).

And the key factor that helps us devalue the Options is Theta.

Think of it like you’re holding an ice cream cone in Summer.

Over time, that ice cream will melt until you’re just left with the cone.

Similarly, all Extrinsic Value will go to zero at the Option’s expiration.

So when you sell not one but two Short Options with the Short Strangle, you have maximum Theta working for you to decay those Options.

Unlike the Iron Condor (the defined-risk counterpart of the Short Strangle), there are no Long Options to negate the Theta effects.

So with the Short Strangle, often you’d find that you’d be able to take profit much quicker than the Iron Condor.

Reason #2: No Need To Pick A Direction

One of the most difficult things to do is to predict a market direction.

In the traditional world of trading (without Options), you must pick a direction to trade in.

Either you trade Long if you think the market is going up.

Or, you trade Short if you think the market is going down.

And that’s why most people struggle to be profitable.

But with Options, you don’t need to pick a direction to be profitable.

You can say, “I don’t know if the market will go up or down, but I do know that there’s a high probability that the market will stay in a given range in the next X days”.

It’s much easier to put a trade on this way compared to picking a direction.

Reason #3: Consistent Income By Trading The Expected Move

There’s no better way to generate a consistent income than by trading the Short Strangle.

Now, a neutral Short Strangle is usually placed around the 16 deltas strike price, which is what’s considered the “Expected Move”.

The Expected Move is a term in Options trading that depicts the theoretical range of the underlying stock by expiration.

There are two methods to derive the Expected Move.

The first method is by looking at the Options Chain.

On the right-hand side of the Options Chain, you can see two numbers:

• A percentage number – this is the Implied Volatility (IV).
• A “+/-” number – this is the IV translated into the dollar move either up or down. This is the Expected Move.

So if you take a look at the first Option expiration date of 24 Feb 23 (24), it shows an Expected Move of “+/- 16.05”.

Assuming the current price of the market is $100, the range of the Expected Move would be $83.95 to $116.05.

That means, theoretically, the market has a 68% chance that it will stay within this range by the expiration date of 24 Feb 23.

However, in actual trading, the percentage that the market stays in this range is much higher.

The above shows a study done by the folks at TastyTrade that compare the theoretical win rate of trading the Expected Move, compared to the actual win rate.

While the theory suggests a 68% win rate, the actual win rate ranges from 71% to 85%.

There are also studies done on the three major Index ETFs (SPY, QQQ, IWM) to compare the difference between the theoretical Expected Move and the actual Realized Move.

And in all three studies, you can see that the Expected Move is greater than the actual Realized Move.

What this means is that when you trade the Expected Move with the Short Strangle, you will win more than the theoretical 68% suggests.

And this will lead to overall profitability with the strategy.

Understanding The Short Strangle’s Risk

If you were to construct the Short Strangle with the 16 delta Options, the risk profile would look like this:

From this risk profile, you can see that the Short Strangle has a very high win rate.

However, what scares many people is how small the maximum profit is compared to the potential losses at the end of both sides.

That is why many traders shun trading this.

While in theory, it’s possible to potentially lose a lot, practicality-wise, it’s very unlikely.

So how do we measure what’s the possible maximum loss for a Short Strangle?

It’s by using the Buying Power Requirement (BPR).

The BPR is the capital you’re required to put up for the trade.

On the TastyTrade platform, when placing your trades, the BPR will be shown at the bottom-right of the screen.

Studies have shown that when trading the Short Strangle, the BPR encompasses nearly all the losses for the strategy.

This is an extremely important and powerful piece of research because it tells us that as long as we close our Short Strangle trades at 21 days-to-expiration (DTE), the maximum loss would be contained within the BPR.

So if the BPR is $1,000 for the trade, that means that all our losing trades would have a loss that is less than $1,000 when the IV level is higher than 20.

This is also what I experience when I trade the Short Strangle.

By taking the last 100 trades I did with the Short Strangle, my win rate was 77%.

This is more than the theoretical 68% win rate.

The BPR for each of these trades is around $2,800.

However, my biggest loss is only $449, which is nowhere near the BPR amount.

So while the theory and risk profile might paint a scary picture for trading the Short Strangle, in reality, the numbers are much better.

Thus, the Short Strangle is a great strategy for generating consistent income.

4 Methods To Reduce Risk With The Short Strangle

Nevertheless, because we are trading naked Options with the Short Strangle, it’s important to manage our risk so that no single trade can wipe out our trading account.

So here are four methods to significantly reduce the risk when trading this strategy.

Method #1: Ensure BPR is no more than 5% of your capital.

If you have a trading capital that is $10,000, then you want to ensure that the BPR of each trade is no more than $500.

That’s because, in the unlikely event that the BPR loss is hit, you lose at most 5% of your capital and not more than that.

This way you still have enough capital to continue trading and recoup those losses.

If the BPR is $1,000, then it means the trade is too big for your account size.

In this case, you’d want to find a smaller product to trade.

Method #2: Never take your trade past 21 DTE.

The research piece I showed you earlier is based on closing your trades out at 21 DTE.

If you were to hold your trades to expiration, then the loss could be greater than the BPR.

For example, if I gave you one minute to run as far as you can compared to if I gave you three minutes to do the same, you would certainly be able to run further if you were given three minutes.

Similarly, when you give more time to the trade, there’s the possibility the market would be able to move further.

And that could significantly exceed the Expected Move range.

Hence, when trading the Short Strangle, we always want to manage our trades at 21 DTE (either adjust or close out your trade).

Method #3: Trade Index ETFs instead of individual stocks.

Individual stocks are always more volatile than Index ETFs.

That’s because Index ETFs are a basket of stocks.

Some stocks will go up and some will go down.

So the aggregate move of all the stocks that make up the Index ETF will not be as big as an individual stock.

And when trading the Expected Move, we always want the market to stay within the range.

It’s when the market goes outside of the range that we can start to see significant losses.

Method #4: Spreading out trades.

I’m sure you’ve heard that diversifying across different stocks is a good way to reduce risk.

However, when the market crashes, all the stocks will crash at the same time.

And when that happens, all your positions will take a hit at the same time.

So instead of diversifying across different stocks, you can diversify through your Option trade mechanics by:

• Time – Enter trades at different times. For example, you may enter a trade today and enter another trade a few days later.
• Price Levels – When you enter trades at different price levels, you will have differing P&L for each trade and that can overall smoothen your equity curve over the long run.
• Strike Price – By using different strike prices, you will have different risk profiles that also contribute to smoothing your equity curve over the long run.
• Expiration Dates – When each of your trades has a different expiration date, it further brings diversification to your P&L because each trade will be in its own time frame to work out.

Overall, when you diversify by Option mechanics, you’re able to reduce the risk of any outlier moves significantly.