• Short 1 OTM (out of the money) put.
• Short 1 OTM call on the same date.

<Risk chart of a short strangle retrieved from OptionStrat>

This directionally-neutral strategy can be VERY DANGEROUS because its potential risk is unlimited if the market rips upward. You would not want to attempt this unless you would be willing to take on the equivalent risk of being short 100 shares per options contract and also the risk of being long 100 shares. A short strangle has severe risk in both directions, and it has more tail risk than a short straddle.

A short strangle counts on the underlying price to expire within a certain range (in between the strikes plus the amount of extra padding from the premium received). If closing early for a profit, then the trader is betting on IV (implied volatility) to decline or for the price to have moved less than the options market has priced in by that point. The main driver for short-term profits on strangles is a major shift in implied volatility. 

Intermediate: Strategy

Since a short strangle carries so much tail risk with them, there is good reason to manage it such as to exit if it is becoming too dangerous to take profits if it is doing surprisingly well ahead of schedule. Rather than waiting for expiration, a common and practical approach is to play these with a profit target, such as at 50% max profit. One would typically close these during a sharp decrease in implied volatility.

A trader might open a short strangle when in positive market gamma since that is when volatility is more likely to remain contained or decrease. Conversely, a trader might consider opening a long strangle (a long put and long call at the same strike) if expecting an increase in volatility, such as underneath the Volatility Trigger™.

Advanced: Tail Risk on Short Strangles vs Short Straddles

A short strangle always has more tail risk than a short straddle. Short strangles have more accuracy than short straddles but they always have a larger penalty if they become in-the-money and are facing assignment. “By choosing to sell a strangle instead of a straddle, a trader is gaining an increased median return in exchange for greater extreme risks” (Sinclair, 2020, p. 93). By analogy, a short strangle is like hitting the side of a barn. The wider the short strangle the larger the barn, but the more trouble you are in if you happen to miss the barn.

Let's say that you have a short straddle on a stock for $5 of total premium ($500 notional). But then you have a very wide short strangle with only 10 cents of premium that is 20 strikes out in both directions ($10 notional). There is a very high chance that this short strangle will become profitable; the chance of profit is higher than the short straddle. But if there is an extreme move and that short strangle gets tested, moving more than 20 points, then that will be a $2,000 loss with only $10 of padding vs $500 of padding from the short straddle. 

Another factor here is the reward/risk dynamic. The short straddle can make up to $500 but that very wide short strangle has a max profit of $10. The wider the short strangle, the more tail risk and the worse the reward/risk dynamic. Regarding potentially big moves, this is what they call picking up pennies in front of a steamroller (in this case picking up dimes).

There is an extra element of danger here when traders see the high accuracy of a wide short strangle but also its lower payout, and they compensate by using more contracts, feeling safe because of that higher accuracy. This kind of tail risk can become existential. In order to match the same max profit with the wide short strangle, then 50 contracts would be needed instead of one. That now makes the [50 lot] short strangle's risk $100,000 in the event of assignment, as opposed to only $1,500 from one lot of a short straddle getting assigned on a 20-point move with $500 of padding.

As another consideration, a short strangle is a less precise way to trade volatility than a straddle. And the short strangle’s higher win rate makes it easier to fool oneself about the accuracy of a volatility trading strategy (Sinclair, p. 92). What that means is a trader must be extra careful when trying to measure a short strangle’s performance by past success since the high win rate can lead to long winning streaks which do not reflect the big picture of risk.

gamma: A second-order Greek which compares changes in delta (directional exposure) to changes in the underlying. In general, gamma means the acceleration of directional exposure. Gamma is also one of the main properties of an option: All long options are long gamma. In a way, gamma is thought of as the magic of options because the size of directional exposure (delta) increases as it is right about direction (therefore increasing profits), and it decreases when it is wrong about direction (therefore decreasing losses). But the cost for this magic is time decay. The connection to market makers is that when they are long gamma (market gamma is positive) then they trade against the direction of the trend to lock in profits after they have favorable moves with increased size thanks to gamma. This is why positive market gamma tends to create an environment of reduced or reducing realized volatility (smaller overall price moves).

IV (implied volatility): The expected percentage range over a year with 68.3% confidence. This is based on options pricing at one standard deviation. Long options benefit from increases in implied volatility and short options benefit from decreases in implied volatility. In general, when implied volatility increases it means that the expected percentage range is getting larger. When implied volatility is applied to lengths of time other than one year, then this is called the expected move.

OTM (out-of-the-money): An option is out-of-the-money if it would have zero value expiring with the underlying at its current price. When an option is out-of-the-money, its entire price is made of extrinsic value, which is a premium that option buyers are willing to pay for an opportunity to make a profit.

RV (realized volatility): Shows the actual trading range of how much a stock is moving over a specific period. It is calculated based on historical movements, and measures the standard deviation, which means about how far it can be expected to move with a 68.3% chance. Another way to look at it is that 68.3% of historical moves would have fallen under what is measured as a standard deviation. Realized volatility can be applied to any length of time. It can also be used as a forecast of future [realized] volatility.

spot: The immediate delivery price of an underlying security. Shares are always considered the spot price, while options are a derivative of that. We also referred to index prices as spot—in contrast to futures or options on them.

stop limit: In trade management, a stop limit is a limit order that makes a transaction to open or close a trade only if at the same price or better as the limit order price. A stop limit order has two parts: first a trigger is hit if the price breaches a price point (as is true with all stop orders) and second it has a limit order to guard the execution, which is the worst fill price allowed. If used to close a trade, then this is limiting a loss if there is a price available in the range between the stop order trigger and the limit order. There is risk with a stop limit order in that if a stock gaps downward and there is no liquidity, you may not have an execution, and experience higher losses as you remain fully exposed to your position. Stop orders are safer in general than stop limit orders if it is necessary that a stop gets filled at all costs.

straddle: A vertical option strategy which is long a call and long a put at the same strike (long straddle) or that is short a put and short a call at the same strike (short straddle). For retail traders, this is arguably the cleanest way to trade volatility (changes in the percentage range of a security) directly.

strangle: A vertical option strategy which is long an OTM (out of the money) put and long an OTM call at different strikes (long strangle) or that is short an OTM call and short an OTM put at different strikes. Like a straddle, a strangle is a way to trade volatility. Long strangles have less accuracy and less cost than long straddles; short strangles have more accuracy and more risk than short straddles.

strike: The price that an option is based on. A long call will expire worthless if the price of the underlying security finishes underneath the strike price, and a long put will expire worthless if the underlying finishes above the strike price.

tail risk: Sometimes referred to as "black swan" risk, a tail event is an unlikely scenario that would have a devastating effect. The primary purpose of hedging is to soften the blow of tail risk. 

volatility: When we say volatility in trading, we usually mean either implied volatility (IV) or realized volatility (RV). Volatility-sensitive trades have the extra dimension of not only needing to be right about price, but also needing to be right about how quickly price can move (or not move) compared to what the market is pricing in. In many ways, volatility means the speed of market movement; volatility traders will make bets on whether prices will move faster or slower than expected. The overlap between IV and RV is that they are based on one standard deviation moves (68.3% confidence). Also, the slang “vol” is usually considered a reference to IV, especially as “event vol”. For clarity, it is usually helpful to specify explicitly whether we mean IV or RV.

VT (Volatility Trigger™): The VT is our proprietary indicator which detects the level below which we expect bearish feedback loops (chain reactions) to start kicking in. Above this level we expect bullish flows that lead to relatively lower market volatility. Underneath the VT, realized volatility (the expected percentage range over a period of time based on historical data with 68.3% confidence) is modeled to expand significantly. In the Equity Hub™, a similar calculation is used for what is called the Hedge Wall.