FIN486

Fall Semester 2014

Michael Galindo & Russell Carter

Short Strangle Options

The objective of this strategy is to maximize our return on capital while reducing our
market exposure for each trade that we initiate, our approach can be considered contrarian,
buying premium into weakness and selling premium into strength. At any given time, depending
on a few key statistics, we will open a naked short position and or use short strangles, preferably
within 1 standard deviation of the mean. The main statistics that we will pay the most attention to
before deciding to enter into any new position will be; implied volatility, implied volatility
ranges, liquidity, binary events (earnings), and price action in correlation with volume. Also
taken into consideration will be our existing portfolio (for diversification purposes), and overall
market conditions.
Selling premium will be our main focus, seeing as how the odds seem to favor selling
rather than buying. Based on data obtained from the CME, I analyzed five major CME option
markets - the S&P 500, Eurodollars, Japanese yen, live cattle and Nasdaq 100 - and discovered
that three out of every four options expired worthless. In fact, of put options alone, 82.6%
expired worthless for these five markets. (Summa, Investopedia) Though this was taken from a
study used in the late 90s it still holds relevance in todays options market. Overall the data
suggests that option sellers have an advantage in the form of a bias towards options expiring out
of the money (worthless).
Moving forward, implied volatility (going forward we will refer to implied volatility as
IV) is a very important statistic in our underlying selection. IV tells us the expected move and is
a key factor in the pricing of options. In our selection process, we look to compare IV to the
overall market and correlated products. The IV range is a look at the IV relative to its high and
low IV over a period of time. We look for underlyings that are trading high in its IV range to
possibly play for an IV mean reversion.

The use of IV rank (IV percentile) gives us a sense of where the current implied volatility
stands compared to where it has been over the previous trading year. Investors recommend that
selling premium when IV rank is high results in a higher probability of success and return on
capital. Referencing the IPO of Alibaba Inc. (BABA), investors were suggesting using strangle
strategies in order to receive a greater profit due to the high IV at the time, although there was
little data in regards to its stock at the time. Consider setting a BABA Strangle by selling the
November $85 puts and the November $95 calls. You can sell the $85 puts for $3.40 and the $95
calls for $1.95 to net a total of $5.53 multiplied by any number of contracts you sell and by 100.
Selling 50 contracts for strangle should net you $27,650, which you can keep if shares of Alibaba
are between $85 and $95 on November 22 (Algabe 2014) .Higher IV allows us to collect a
greater amount of premium, extend our breakeven points and increase our overall probability of
success. Also, since volatility is a mean reverting function, it tends to contract from higher levels
and expand from lower levels.
We look to liquid products as these will offer the most efficiently priced options.
Liquidity allows us to easily trade in and out of positions, and we give up less edge each time we
place a trade. High open interest and tight bid/ask spreads are key indications of liquidity. We
also use earnings announcements and binary events for trading potential. These events have a
significant impact on IV. Being aware of these events and their effect on option pricing is critical
in our underlying selection.
Using the illustration below I will explain the use of the strangle strategy using a short. If
a stock is trading at $40 in August with an expiration date being in September a trader would
execute a short strangle by purchasing a put for $100 with an exercise price of $35, and an
August call for the same price and exercise price of $45. If on the expiration date the stock is

trading at $40 the put expires worthless but the call expires in the money and has an intrinsic
value of $500. By taking away the initial $200 invested the traders profit comes to $300.

The hopes of the short strangle strategy like stated earlier is to try to limit risk, but also
attempt to make large gains while reviewing a things such as the IV, past stock history, and the
spread between the standard deviation. The profit pattern obtained with a strangle depends on
how close together the strike prices are. The farther they are apart, the less the downside risk and
the farther the stock price has to move for a profit to be realized (Hull 2014). Utilizing the short
strangle approach would in essence help realize a gain for the investor.

References
Algabe, V. (n.d.). Alibaba inc the one strangle you should know about baba options. Retrieved from
dailyoptionalerts.com: http://dailyoptionalerts.com/2014/10/02/1237-alibaba-inc-the-onestrangle-you-should-know-about-baba-options/
Hull, J. C. (2014). Options, Futures, and Other Derivatives. Pearson.
Summa, John. "Do Option Sellers Have a Trading Edge?" Investopedia. N.p., n.d. Web. 28 Nov.
2014.

Additional information on IV rank:

www.investools.com/tdameritrade/
www.tastytrade.com/