Short strangles are a great options strategy, but a given % of times, they will be tested, and the sides will be breached. This has negative consequences on not just your P/L, but also your state-of-mind. Being a naked options strategy, short strangles can actually result in huge draw downs, if the instrument prices don’t go our way.
So what can you do with a short strangle which is turning ugly? You can modify your trade several ways actually.
Backtesting data suggests that in the long run, closing a losing strangle and moving on to the next trade is a good way to minimize losses. This strategy is straight forward.
Let’s say you got $600 in premium for selling a short strangle. According to this defense strategy, you close it when the implied loss of the trade reaches $1,800.
This strategy is not my favorite, since it doesn’t allow for any subjective modification to the trade.
This strategy requires the trader to roll both the put and call sides of the trade up or down, when the tested side reaches a predetermined delta value. This value is usually 30 deltas, the reason being that at this level, the price of this modification isn’t that large yet.
For example, let’s say the original short strangle was 1 contract each, opened at 100 -P and 110 -C, and the price of the underlying was 105. The price moves up, and the short CALL reached a delta of 30. At this point, you would roll the 100 CALL out a few strikes, and bring the short PUT along with it, for example 113 -C with 103 -P.
The net effect is that the maximum profit is decreased, while the delta of the trade is re-balanced.
Beginners love this trade adjustment, since it rebalances their deltas (and anxiety levels) when the trade doesn’t go as planned. But the thing is that you can only do this once or twice, before all potential trade profits are gone.
A version of this strategy is to bring the untested side in closer, so that distance between our 2 strikes is less than what we opened the trade with.
In continuation of the example above, this would mean that we bring the short PUT in further, to 105 for example.
The net effect is 2 fold: First, the max profit isn’t reduced by as much, second, the risk of the trade grows, since the strikes are now closer together.
This one is better than the original version, but it does increase your risk. If the trade quickly moves against you, it’s difficult to keep up, since after 2-3 adjustments, your strikes are so close together, that there is no more wiggle room for even normal volatility.
Another version of this strategy is to double down on each roll.
This would mean that instead of selling just a single option at each new strike, you double each time you roll.
The net effect is that the max profit stays about the same (depending on how far you roll the strikes), but your risk effectively doubles, since you have double your original position. This requires double margin, and double anxiety if the trade continues to go against us.
This sounds good in theory, sort of like the Martingale system with betting. Just double down, your luck will turn at one time, right? Well, this is where the gamblers fallacy comes into play. You might run out of money before your luck turns. In other words, if the price keeps on moving against you, there are only so many number of times you can double. Not to forget that each time you do so, your implied losses will increase at a much higher rate as well.
This is a pretty straight forward strategy. All you need to do, is roll up/down the untested side of the strangle, when the price of the underlying moves past the other side’s strike. The breached side is left untouched.
For example, let’s say the original short strangle was 1 contract each, opened at 100 -P and 110 -C, and the price of the underlying was 105. The price moves up to 110.2, so the short CALL is breached. At this point, you would roll the 100 PUT up to whichever strike has 30 deltas.
The net effect is that the break-even point on the breached side is pushed out by as much premium as you collect for rolling up to the 30 delta.
You would think that the 30 delta is too high, since the price might go into correction. Backtesting with the S&P shows this to be effective, as the price of the underlying rarely goes back to reach the adjusted strike as well. I am not aware of this backtest having been conducted for other underlyings though.
The problem with this strategy is usually not that the price will correct to the adjusted strike. The problem is that the price keeps on going against us, but the breached option is left untouched, meaning it packs on large losses. You would have to keep on rolling the untested strike, following the price move, but it will be hard to break even if the price starts trending against us.
This defensive strategy is best used, when the original short strangle is opened in such a way, where the strikes are 1-2 strikes above/below technical lines of resistance.
You would initiate this adjustment once the technical resistance level is breached, and becomes support, since this is when you have reason to believe that the price will not correct back. At this time, you BUY an option 1-2 strikes further from the tested side, thereby setting a maximum loss to the tested side of the strangle.
Going long an option will greatly reduce your maximum profit potential, so with this strategy, you also roll the untested side closer, to collect more premium.
For example, let’s say the original short strangle was 1 contract each, opened at 100 -P and 110 -C, and the price of the underlying was 105, with a strong technical resistance level at 109. The price moves up and closes above 109. At this point, you would roll the 100 PUT up a few strikes, but more importantly, buy a Long CALL at 111 to maximize your losses, in case the trend continues.
From here on, you would need to keep an eye on the price of the underlying, since if it turns out to be a failed break-out from the technical level, you would need to close your Long position.
This strategy is very versatile, in that it limits potential losses, while allowing for further adjustments.