In effort to learn different income producing options strategy I have been reviewing various strategies and deciding whether they are appropriate for me to actually trade. Lat week I reviewed the very popular Strangle Option Strategy and prematurely stated, it isn’t something that I would be interested in selling any time soon. It took another blogger, JC from Passive Income Pursuit, to force me to look at the strategy from a different angle. His single comment gave rise to me selling strangles!
How Does Selling a Strangle Option Work?
While my post defining a strangle option went into much more detail, a Strangle, is actually a pretty easy strategy to understand if you have a basic knowledge of options. When a person writes a strangle they are:
- Selling an out of the money put
- Selling an out of the money call
- The seller is collecting a premium taking the position that that the stock won’t go below a price certain (in the above example that number is $35/share); and
- The seller is collecting a premium taking the position that the stock won’t go above a price certain (in the above example that number is $45/share).
So, as long as the stock stays within the range above ($35 – $45) the strangle seller receiving two premiums.
Why Was I Against Selling Strangles At First?
As soon as I started researching the strangle, I thought to myself that the strategy was not for me for one reason that I explicitly shared,
I am not sure why a retail investor would sell a short strangle. The risk seems absolutely ludicrous. I am sure there is an application for professionals, but the idea of guessing whether a company is going to stay lower than a particular strike price (selling to open a call) seems like a very, very risky proposition.
Put a different way, I do not understand selling uncovered calls. If a stock goes above the strike price, I am just basically paying out of pocket the difference between the actual stock price and the strike price. I look at this differently than being assigned a put since if I were to “lose” that position at least I am holding 100 shares of a company.
How was I convinced to Write Strangles?
A few hours after that post went live JC wrote,
…I’m a bit surprised that a short strangle doesn’t sound like something you’d be willing to do. Unless you’re using options solely to exit positions/increase income via covered calls or cash secured puts in order to enter positions, I don’t see why a short strangle is all that different from just selling a call or put…I’ve also been doing covered strangles in order to generate more option income/premium or reduce my cost basis on positions where I own 100 shares. So far it’s worked out pretty well.
It may seem elementary for experienced traders, but JC provided me with a paradigm shift. I was looking at the strategy with a bias against selling uncovered calls, but he was completely correct – I was holding a few positions wherein I was assigned shares at a paper loss, so why not take a bet on both sides of those companies?
From what I figure there are three mutually exclusive outcomes:
- The stock stays within the predefined range and I keep both premiums
- The stock drops and I am assigned new shares reducing my cost basis (remember I already own shares)
- The stock pops and I keep the premium and I get out from under the position
Highlighting my First Few Strangle Sales
The First trade I did was to pair up a covered call I already had on the books. At some point in the past (timing doesn’t really matter for this post) I was assigned AOBC (Smith and Wesson) shares at a cost basis of $23. Since that assignment I was selling covered calls little by little to make up the difference between the current price and the assignment price. Well, with JC’s comment it made me realize, if I am long on the company why not pair it up with selling a put. Again, if the stock is put to me all it does is reduce my cost basis since I do not have any plans of unloading the stock anytime soon.
The second trade I did was a true (covered) strangle. Currently, I am holding a few hundred shares of URBN, but only did one trade (100 shares) wherein I sold two separate contracts:
- May 12 $20 Put for $.18
- May 12 $26 Call for $.12
The reason I only did 100 shares was that my basis in the 400 shares is in the 30s, so I didn’t want the whole thing sold from underneath me in case there is a huge jump. Instead, my plan is to keep selling 1 or 2 contracts at a time, waiting for the company to recover.