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Strangle This Trading Range

But if the market is able to calm down, consolidate over the next two weeks and still trade between 1220 and 1240 as of Dec. 1, or two weeks from today, you can expect time decay to bring the 1220/1250 strangle's value down from $18 to approximately $10 during those 14 trading days. That's a 44% reduction in value, which translates into a 28% return on investment (standard margin rules applied).

If this type of profit is available at that time, I would suggest closing out the position. Trying to carry a naked option position all the way to expiration increases the risk, without a commensurate increase in the potential reward.

Limiting the Risk

Naked selling of straddles and strangles comes with unlimited risk; it should be done on short-term trades, not as part of an ongoing rolling position. So if you do want to play the premium collection game, I would suggest employing a condor strategy.

A condor consists of four strikes (a reasonable commission structure and efficient execution platform are prerequisites) that can be described most simply as having both a vertical call spread and a vertical put spread. Using the example above, one might sell the 1220/1200 put spread for a net credit of $5 and sell the 1250/1270 call spread for net credit of $5, which gives the iron condor a net credit and maximum profit if $10.

Note, however, that the maximum risk is also $10, the premium collected plus the difference between the long and short strikes (1220-1200 +10 or 1270-1250 +10).

Because the condor has limited risk, it can be used to cover a wider range and held for a longer period of time. Again, it might be prudent to close out the position before expiration rather then trying to squeeze out every last nickel of time decay. The longer you remain short options, the greater the likelihood something can go wrong.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback; click here to send him an email.

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