Establishing & Managing Short Strangles for High PoP

I have been gradually moving away from the wheel strategy and toward undefined risk strategies over the past several months. Undefined risk strategies (short strangles and straddles and their derivatives) are more efficient on buying power, award higher premiums, and offer more management options.

In exchange for these advantages, the strangle seller goes into management mode immediately after opening the trade. The trader must frequently view the underlying stock's price action to determine when to adjust one or both legs, or to close the position entirely.  

When managed by the numbers, some management approaches will turn a profit 9/10 times, according to backtesting performed by tastytrade.

In this post, we will look at establishing and managing short strangles with a focus on probability of profit (PoP) and return on capital (ROC).

What is a short strangle?

As a refresher, a short strangle consists of selling an OTM put and an OTM call. The sales will award premium. 

For example, assume WSB is trading for $100. The trader wants to generate premium, so he sells the $95 put for $250 premium and the $105 call for $250 premium. The expiration date on both contracts is 45 days away. The combined sale awards $500 premium.  

The trader's goal is to buy back his short call and put for a combined total of less than $500. He keeps the difference. Alternatively, the trader can wait for the contracts to expire worthless, with a price between $95 and $105. In that case, the trader will realize the whole $500 gain.

Keep in mind that in real strangles, the put will often have more premium than the call, even at the same delta. Stocks tend to drop faster than they rise, so put buyers are willing to pay a premium on their premium.

How should we establish short strangles?

Short strangle traders want a stock to move sideways until expiration. Ideally, a stock would trade in a tight pattern between our short strikes until expiration, allowing us to realize the max gain.

However, life is not that easy. Stocks will move around, sometimes approaching or even piercing our short strikes. When that happens, it is often in our best interest to manage the strangle by adjusting strikes or expiration dates. Since managing can become complicated, we stand our best chance of having a successful trade by selecting short strikes that give us a high PoP.

To establish a strangle, we must use delta as our primary piece of information. Delta shows you how much your contract's value will change based on a $1 change in the underlying. However, delta can also serve as a proxy of how often the stock will pierce that strike.

For example, a call with a 0.16 delta indicates that the market believes the stock has ~16% chance of rising above that strike by expiration, and an 84% chance of expiring below it and expiring worthless.

If we now sell a short call at the 0.16 delta and short put at the same delta on the other end, the our 8th grade arithmetic gives us the following:

84% chance the call expires worthless;
84% change the put expires worthless.

0.84 * 0.84 = 0.705

70.5% chance that both contracts expire worthless and the trader realizes the max gain while doing nothing. 

On a bell curve, one standard deviation captures 68% of data (68% of outcomes). Because 0.16 deltas produce about the same result, the 0.16 delta strangles are also called one standard deviation strangles. In reality, you will rarely find a strangle with a perfect 0.16 delta on both ends, but as long as you are close, you can call it one standard deviation.

A 70.5% chance of max profit is already pretty good, but perhaps not enough to count on as income. 

If the trader wants a higher probability of max gain, he can sell 2 standard deviations away at the 0.03 delta. 0.97 * 0.97 = 0.94, or 94% chance of max gain. That's a great probability of profit on max gain, but selling 0.03 delta strangles barely pays any premium.

On the other hand, a trader who sells the 0.30 delta strangles is selling the 1/2 standard deviation and accepts ~49% chance of both strikes expiring worthless vs ~51% chance of one leg expiring ITM.

According to tastytrade, extensive backtesting indicates that the ideal balance is to sell the 0.16 delta strangles expiring 45 days out, and closed at 50% profit. But even more importantly, the distant date and OTM strikes leave a lot of flexibility for adjustments.

How should we manage our strangle when we are green?

Your strangle has been open for 25 days. You're up 40% of the max gain, and you've got about 3 weeks left before expiration. Should you close the strangle and take the gains?

Closing a profitable strangle is a mixed bag. On the one hand, you're happy to take the gain. On the other, you've got to return some of your premium, and you're missing out on potentially more gains. 

Theta decay really starts kicking in the final week before expiration, so closing a 45-DTE strangle for 60% gain after 38 days of holding feels like a waste. Why not hold for just one more week and take the other 40%?

Here's why: You know what's worse than waiting 5 weeks for 60% gain? Waiting 6 weeks for a 80% loss.

Close to expiration, a sharp move in either direction can cut you up big time, and you don't have a lot of time left to make adjustments. I have, plenty of times, refused to sell a spread at 85% gain because I wanted to squeeze out that last 15%. The stock moves 5% on that Friday, and my 85% gain gets wiped out and goes red.

We should avoid that fate. According to tastytrade, extensive backtesting shows that looking to close your strangles ~15 DTE is ideal, provided the trade cannot be closed prior. They seek to avoid holding undefined risk positions within 2 weeks of expiration.

The same study showed that if the trader elects to take profits at 50% gain, then he will close ~90% of his 0.16 delta strangles that way. If the trader is willing to close at 25% gain, that rate increases to 95%. 

Recommendation: Determine your trade goals prior to entering the trade and be prepared to close early. If the trader wants consistent return, sell 0.16 delta strangles expiring in 45 days and close at 25%. If the trader is willing to accept more risk of assignment in exchange for more premium, then trade the 0.30 delta and close for 50% gain.

Considerations: Tasty's backtesting utilized only SPY. If the trader is using a single underlying stock instead of the S&P 500 ETF, events like earnings or other news can move the stock dramatically and increase the probability of assignment. Also, the backtesting covered more than 10 years of data. It is possible that the losing percentage was not evenly distributed, but rather localized to certain market conditions.

How should we manage when our strangle goes red?

On the less fun side, we have management options when the trade goes against us. When we trade strangles, our trade can turn red in two ways:

1) volatility spikes increase the price of our options on both legs; and
2) the stock moves too sharply in one direction.

In case 1, an increase in volatility will increase the value of the contracts we sold. This is problematic for us because closing the position would require spending more money than we received for opening the strangle. Strangles are volatility negative and therefore an increase in volatility is detrimental to the position. The theoretical ideal is that volatility drops to 0 during the life of the strangle, and it has no means of moving beyond the strikes. This would offer the trader 100% gain every time.

In case 2, the stock moves so far in one direction that the premium received does not compensate for the loss on one of the legs. If the trader opens a 0.30 strangle and the stock drops too far, the money he gains from his short call losing value cannot compensate for his short put's losses. Although short strangles start delta neutral, they can become delta negative or positive depending on the price action.

Managing losses due to volatility spike

If volatility increases, you can lose money on both legs of your strangle simultaneously. It sucks when the stock stays flat between your strangles, and yet IV increasing costs you money on both ends.

Fortunately, managing in this situation is almost always very easy.

If the stock is between your strikes, you are almost always best off doing nothing. Volatility only spikes under certain circumstances, and if you are red on both legs, then the stock price will almost always be squarely between your strikes.

In this situation, your best approach is to hold the position you have and await volatility's return to its pre-spike range. If IV spikes high enough, consider selling another strangle to take advantage of the high premium and opportunity for IV crush.

There is an exception: If volatility spikes because of a pending event that you reasonably expect to launch the stock in one direction or another (pending results of an FDA decision, for example), then there is nothing wrong with closing early for a loss. It's certainly not ideal, but the trader has to manage his risk tolerance.

Managing due to stock price movement

Short strangles begin as delta neutral positions. When the stock rises, the short call loses money but the short put gains. These changes offset. However, short strangles are gamma negative, meaning that once a stock gets too close to one of your strikes, your deltas no longer balance and your losses accelerate the further the stock moves in one direction.

In a theoretical worst-case scenario, a stock will continue climbing each day until your short call reaches 1.00 delta and your short put has near-zero value left to lose.

To prevent those devastating losses, we can take steps to manage the strangle after it's opened. These methods involve rolling the untested (safe) leg of your strangle closer to the stock price to collect more premium, or rolling either leg out in time.

1) The stock approaches one of your strikes but does not test it yet: Regard your overall delta and determine if you believe the stock will continue on the same trajectory. If your delta is now -0.30, for example, it may be time to preemptively roll your untested side. If you do not have particular reason to believe the stock will continue and test one of your legs, the best answer is to usually do nothing and let theta to continue decaying.

2) The stock tests one of your strikes: Take a close look at your deltas as before, and strongly consider rolling your untested side to collect more premium. 

Rolling up the puts wing during a tested short call will grant the trader additional premium to extend his breakeven higher. Just as importantly, it adds some premium back onto the puts wing, so if the stock does continue higher still, the short put will award some gains.

3) The stock makes a decisive move past one of your strikes: If you have not rolled once already, now is almost certainly the time to do so. Your breakeven is likely already being tested, and your deltas are all lopsided. 

If rolling your untested wing to a strike closer to the stock price is not enough to get your deltas close to neutral, then consider also adding time to your untested wing by rolling out in time in addition. This will likely necessitate rolling the tested side as well in order to keep you from being naked on either end. Keep in mind rolling out both strikes will also allow ample space to bring your deltas back to neutral.

4) The stock has made a decisive move beyond your breakeven: Once your breakeven is blown, consider rolling the untested side into a straddle. Achieve this by rolling your untested side to the same strike as the leg that has been blown out. In principle, this has the same effect of just rolling the untested side close to the stock price, but is more aggressive.

5) The stock has gone even further from your strangle and your position appears irredeemable: You can either roll your untested side even further, into an inverted strangle to collect more premium, or you can roll both legs out in time. I prefer the latter. As long as you didn't wait too long before beginning your management, you can likely recover adequate premium by rolling each the tested and untested side out in time to collect more premium.

Ideally, you will want to adjust your short strikes such that both legs are once again OTM. However, that may not be feasible. In that case, consider rolling out into a straddle and reinitiating management from there.

Recommendation: Roll your untested side as soon as the stock starts testing the other strike. Rolling up early will allow you additional space for further management later. Roll up again into a straddle if your breakeven gets tested. If the stock continues further, consider rolling both strikes out in time and rebracketing your strikes rather than going inverted. Stick to indexed ETFs when using strangles to maximize PoP, as opposed to single-stock underlyings that can move in one direction longer. 

Considerations: Owning shares of the underlying provides additional delta to protect your overall position to the upside if the underlying goes too high. Remember to consider the effects of ex-dividend date on your strangles as well. Expect the stock to open red by the amount of the dividend on ex-dividend day.

What are the benefits of managing?

If we set up our strangles at appropriate deltas and manage at 25% or 50% gain, our PoP is already remarkably high. Why do we need to manage at all rather than just letting our strangles expire or taking gains at a predetermined price?

1) Not all "wins" are equal: In most backtests, a "win" is classified as any trade that ends profitably, whether it be max gain or 0.5% gain. Although non-managed trades still show a strong percentage of winning, making 1% over 45 days isn't a good return on capital (ROC) for the risk you're taking.

By rolling untested legs, we collect additional premium that pushes out our breakevens and turns our 1% gains into 10% gains; 10% gains into 40% gains; and 100% gains into 120% gains (vs the original premium collected).

2) It may be necessary to rebalance your deltas: If a stock moves sharply past one of your strikes, the untested end will probably be sitting at 90% gain with nothing left on it. It provides you no further protection from moves against you because its delta is so low that it cannot offer any more gains. 

By rolling your untested side, you recover some delta in your favor in case the stock continues moving against you. Of course, if the stock reverses, you'll probably have been better off holding the original strike. However, a 0.90 x 0.06 strangle is not the intended position of a strangle, and the trader will not see any significant theta decay in his favor anymore. Managing is typically the better call.