S.O.S. - Short Option Strangles
- Written by Carley Garner
The Anti-Trading Strategy
A less exciting, but perhaps more fundamentally sound, approach to the markets is attempting to profit from a market that is trading in a range. Conceivably, the most efficient method of capitalizing on “quiet” markets is the short option strangle, often referred to as S.O.S. However, short option strangles suffer during spikes of volatility and placement of strike prices well beyond known support and resistance levels are imperative.
Selling short option strangles is the act of selling a call above the market and a put below the market in order to collect a premium in exchange for assuming the risk of the market dropping below the put strike price or above the call strike price. This is sometimes referred to as “trading naked” because the strategy involves theoretically unlimited losses.
The premise of an S.O.S. strategy is similar to the business model used by insurance companies. Insurers collect premium on policies with the expectations of having future payouts. Knowing the probability of a claim, they can project their expected return for assuming the risk of the policyholder. They understand that, over time, they will profit despite their obligation to pay claims. Thus, proponents of the S.O.S. strategy believe that it enables them to benefit from the probabilities as opposed to entering a position hoping to profit on a “long shot”.
Weighing Advantages and Risk of Short Option Trading in the Futures Markets
It should be obvious to you by now that there are clear advantages to selling option premium as opposed to paying for it. However, beginning traders continue to be lured into long option strategies on the basis of limited loss characteristics. Once again, the peril in this approach lies in the fact that although potential loss can be defined, I believe losses to be almost certain in many cases. Most options expire worthless, and even those that expire in the money might not payout enough to cover the premium originally paid. With that said, it is important to note that putting the odds in your favor does not guarantee success but I argue that is a step in the right direction. Doing so can be compared to the difference between rolling the dice and flipping a coin. Naturally, you would want the 50/50 odds of a coin toss as opposed to a one in six chance offered by a dice roll.
We feel that if traders pay attention to technical aspects of a market as well as fundamental and most importantly seasonal tendencies, this trading strategy could potentially be a dependable strategy in the long run. That is not to say that there won’t be losers. As we all know, losing trades are inevitable. The secret is to have the instinct and training to mitigate the damage caused by losing trades because when facing unlimited risk, the stakes are high.
Premium Collection in Commodities, Volume and Volatility
Before even considering selling options, traders should analyze a market’s “climate” and feasibility for the S.O.S trading strategy. The two major aspects to consider include volatility and liquidity.
Volatility is an important factor of the extrinsic value of any given option. Markets that offer enough action to keep option prices inflated but not so much that you can’t sleep at night, are ideal for the S.O.S. strategy. Additionally, selling options is only practical if the option market is liquid enough to allow for easy entry and exit of a trade. Trading in markets that don’t have lot of participants creates a scenario in which the bid / ask spreads can be massive, allowing for excessive slippage. For these reasons, we have deemed that the one of the most advantageous markets to sell premium in is the S&P 500.
Although the margin required for short option S&P plays are considered to be very hefty by some, the nature of the market allows traders to sell relatively wide spreads while still maintaining the potential of reaping a handsome reward. For example, a short strangle 30-45 days prior to expiration with approximately 200 points between strike prices commonly yields $4.00 to $5.00 in premium, which equates to $1,000 to $1,250. The average margin on such a trade is approximately $15,000. However, we recommend that a trader have at least $30,000 in an account in order to execute one S&P strangle. It can be done with less, but that doesn't necessarily mean that it should be. Following this guideline will give traders adequate capital to withstand potential fluctuations in both volatility and margin. While some futures traders snuff at this type of ratio for margin vs. potential return, traders must keep in mind the probability of success. S.O.S. positions can make money if the market goes up, down or sideways. The only catch is that the market can’t go beyond the strike prices.
However, don’t be fooled into believing that being successful is as easy as selling a call and a put 100 points from the current market price and waiting for “pay day”. There is much more involved in terms of skill and risk but I strongly believe that option selling is an optimal strategy if proper risk management techniques are exercised.