What to Do When Your Strangle Gets Tested

Key Concepts

• Short Strangle Adjustment
• Strike Prices
• Directional Bias
• Rolling Options
• Straddle Conversion
• Break-Even Points
• Inverted Strangles
• Credit Collection

Adjusting a Short Strangle: A Step-by-Step Guide

This guide outlines a four-step process for adjusting a short strangle strategy, focusing on managing risk and optimizing potential outcomes as the underlying stock price moves.

Step 1: Stock Price Between Strikes

The initial and most crucial step is to assess the stock's position relative to the short strangle's strike prices.

• Condition: If the underlying stock price is trading between the short call strike and the short put strike.
• Action: "Don't do anything."
• Rationale: This indicates the strategy is performing as intended, and no immediate adjustment is necessary. The goal of a short strangle is for the stock to expire between the strikes, allowing both options to expire worthless and the trader to keep the premium.

Step 2: One Side Tested - Rolling the Untested Side

This step addresses situations where the stock price moves towards or beyond one of the short strikes, testing that side of the strangle.

• Condition: If one side of the strangle (either the call or the put) is "tested," meaning the stock price is approaching or has breached that strike.
• Action: "Roll the other side, the untested side." This involves closing the existing option on the untested side and opening a new option with a different expiration date and/or strike price.
• Objective: To adjust the overall directional bias of the trade.
• Magnitude of Adjustment:
  • 30% Adjustment: "Cut it less, like 30%." This is recommended if the trader wants to maintain a more directional bias towards the side that is being tested.
  • 50% Adjustment: "Cut it more, like 50% if you want to remain less directional." This is recommended if the trader wants to reduce their directional bias and become more neutral.
• Technical Detail: "Rolling" typically involves buying back the existing option and selling a new one, aiming to collect a net credit or minimize the debit. The percentage refers to the reduction in the width of the original strangle, effectively narrowing the profit zone or shifting the breakeven points.

Step 3: Stock Continues to Move Away - Rolling into a Straddle

This step is for when the stock price continues to move aggressively away from the trader's position, making the original strangle increasingly unfavorable.

• Condition: "If the stock keeps running away from you." This implies a strong directional move that is challenging the existing strangle.
• Action: "Consider rolling into a straddle with that same shared strike." This means converting the strangle into a straddle by adjusting both the call and the put to the same strike price.
• Objective: "To maximize your break even point on both sides of the market, specifically the side that you're being tested on." By converting to a straddle, the trader aims to create a wider range of profitability around the chosen strike price, particularly protecting the side that is currently under pressure.
• Technical Detail: A straddle involves buying or selling both a call and a put option with the same strike price and expiration date. In this context, it implies adjusting the existing short strangle components to form a short straddle, likely by rolling the further out-of-the-money option closer to the money or even to the same strike as the in-the-money option.

Step 4: Optional Inversion

This is an advanced and optional adjustment for further risk management or to capitalize on specific market conditions.

• Condition: This step is "optional."
• Action: "You could also go inverted by rolling the put up over the call or rolling the call down below the put."
  • Rolling the put up over the call: This means the short put strike becomes higher than the short call strike.
  • Rolling the call down below the put: This means the short call strike becomes lower than the short put strike.
  • Combined effect: In both scenarios, the strike prices cross, creating an "inverted" position.
• Key Consideration: "The key here is you want to make sure that the credits that you collect on the overall trade still exceed the width of the inversion if at all possible."
• Objective: To potentially profit from the inversion itself, while ensuring the net credit received from the entire trade (original premium plus any adjustment credits) is greater than the difference between the new, crossed strike prices. This aims to maintain a profitable position even with the inverted structure.

Logical Connections and Synthesis

The steps presented form a progressive risk management framework for a short strangle.

1. Initial State: The ideal scenario is for the stock to remain between the strikes (Step 1).
2. Minor Deviation: If the stock moves towards one strike, the strategy is to adjust the other side to recalibrate the directional bias (Step 2). This is a proactive measure to prevent the trade from becoming a significant loser.
3. Significant Deviation: If the stock continues to move unfavorably, the strategy shifts to a more defensive posture by converting to a straddle to widen breakeven points (Step 3). This is a more drastic measure to salvage the trade.
4. Advanced Maneuver: The optional inversion (Step 4) is a sophisticated technique that can be employed to potentially profit from the adjustment itself, provided the net credit remains favorable.

The overarching theme is to manage the trade dynamically based on the underlying's price action, prioritizing the preservation of capital and the collection of premium. The adjustments are designed to either maintain profitability, reduce risk, or even create new profit opportunities as the trade evolves.

Conclusion

Adjusting a short strangle involves a series of calculated steps, starting with inaction when the trade is performing well. When the stock price tests a strike, the trader is advised to roll the untested side to moderate their directional bias. If the stock continues to move away, converting to a straddle can help widen breakeven points. Finally, an optional inversion offers a more advanced strategy to potentially profit from the adjustment itself, provided the net credit is maintained. The core principle is to adapt the strategy based on market movement to manage risk effectively.