Many traders consider the options strategy known as a short strangle to be very risky. But it doesn't have to be, so long as you own shares of the underlying stock and you're fairly certain that they'll continue to trade in a narrow range.
This strategy involves selling a call option that is just out of the money and simultaneously selling a put option that is just out of the money. You collect the premium on both sales. The short strangle is considered a neutral strategy, because you keep the premium if the stock doesn't move much.
The risk comes in because you have sold short a call option. That means that if the stock rises enough in price, the person who bought that option will can exercise it. If that happens, you'll have to obtain shares of the stock and sell them at the strike price. Depending on how much the stock has risen, you could wind up losing a lot of money by paying market price for the stock and then turning around and selling it at the (lower) strike price to the holder of the call option.
Owning enough shares of the underlying stock removes most of that risk, however. (Remember that each option contract covers 100 shares of the underlying stock.) Meanwhile, the short put's market risk is the same as that of a covered call. Thus, the covered short strangle can serve as a low-risk move, particularly when a stock has been trading in a narrow consolidation range.
Now let's go back to our example of General Mills. The stock has been navigating a narrow consolidation range between $70 and $72.50 since July 1, as shown on the chart.
If you own shares of General Mills, a covered short strangle can yield current income with relatively low risk. Selecting options that will expire soon is key to this strategy, because the strategy relies on rapid time decay to create a loss of value in the option premium.
The chart also shows no technical signals that the stock is likely to break out of that range soon. Even so, traders who employ this strategy must monitor technical indicators. If and when signs emerge pointing to a breakout, traders should close the side of the trade that would be exposed by the breakout.
A typical covered short strangle could consist of the following contracts:
Sell the Sept. 16 72.50 call, bid 0.51 (less trading costs) = $42
Sell the September 16 70 put, bid 1.03 (less trading costs) = $94
Overall net credit = $136
In this trade, the short call is covered and the short put has the same risk as the covered call. Ideally, the stock price will be between the strike prices when the options expire. Then the contracts will expire worthless, and you'll keep the premium. If one side or the other becomes in the money, however, it would make sense to either close that side of the trade or roll it forward to avoid exercise.