Short strangles – 10 Delta Trading

If you’re here I’m going to assume you understand option basics. If you don’t, get that basic education somewhere, or try my Options Basics page.

First I’ll summarize the 10 Delta Short Strangle Strategy as I implement it. If it all makes sense to you, then you’re ready to proceed with it and prosper. If you’re not clear on what it exactly means, then the discussion below it should fill in the blanks.

My 10 Delta Short Strangles Strategy

Pick a stock with high Implied Volatility Rank. (More on that <here>.)
Pick an expiration date 3 to 10 days out. If it’s Monday or Tuesday, look at THIS Friday’s expiration; if later in the week, look at NEXT Friday.
Find the Put option at about 10 Delta (but not above 12). Validate with Probability ITM: if >12, choose a lower Put strike.
Find the Call option at about 10 Delta with Prob.ITM <12.
Process the order to the point where you see what the Collateral or Buying Power Reduction is.
Divide the Net Credit (after commissions) by that. I target 1% ROI per trading day here.
Calculate 3 to 5% of trading account current value; divide that by BPR to set the number of Contracts.
Place the trade.
Immediately place a Buy-to-Close (BTC) Good-till-Cancelled (GTC) order at 25% of Net Credit (to keep 75%).
Repeat until 80-90% of trading capital is utilized.
Wait for profits to roll in. OR: adjust strikes if they get challenged.
Repeat as trades roll off, staying 80-90% invested.

My Personal Theory Behind the Strategy

First off, I’m generally a believer in the “Random Walk Theory”: markets are random and no one can reliably predict stock prices. It’s with that basis that I present the discussion below. If we can’t consistently predict future stock prices, then we should strive for an options strategy that is likely to be successful regardless of what stock prices do.

BUYING options seems to be hard: you have to get the stock price’s DIRECTION and TIMING right. Say you think AAPL will go up 10% within 30 days for whatever reason. If you buy the stock, you just hold it until it does go up, and you profit. If you buy a Call option, you kind of have to pick the price AAPL is going to, AND the timeframe it will get there in. You might get the 10% move right, but if it takes 2 months instead of 1, you lose. Or it might move up smartly within 30 days, but only 8%: you still lose.

SELLING options seems to be better. I’ve seen it described as, “When selling an option, you don’t have to predict what a stock’s GOING to do, just what it’s NOT going to do.” By that they mean that a stock’s price can basically only do 1 of 3 things: go up, stay the same, or go down. When buying a Call option you need the stock to go up. If it doesn’t, you lose. But when selling a Call option you just need it to NOT go up: it can stay flat or go down and you win.

Say we buy a 30 days-to-expiration (DTE) at-the-money (ATM) call option in Visa. At the end of 30 days, the price of V will be lower, the same, or higher than it was when the call was purchased. Let’s say V closed one cent above the strike price of the call. The call expires worthless, and we lost the premium we paid for it. It doesn’t matter how far below the strike V was, we would’ve lost the same amount of money. It’s kind of a binary thing on the losing side: the call is either worth something or nothing. (But if it’s a winner then it has a variable upside profit.) We lose 2 out of 3 times. (Remember, I’m assuming efficient, random markets with no “edge”.)

So how does the seller fare in this scenario? If V closes below the strike price at expiration, the seller keeps all the premium paid by the buyer at the start of the trade. They profit if V stays flat or goes down. (But if V goes up then they have a variable loss because they have to provide 100 shares of V to the buyer at the strike price, and if they don’t own them (a covered call), then they hav to buy them at market price.)

Astute readers will have noted that it’s not quite this simple, that the call option premium raises the breakeven price. It’s not enough that V close at the strike price, it has to close at the strike price plus premium paid in order for the buyer to profit. Let’s take a look at that next.

First let’s refine the 1-out-of-3 model of stock price action to 5 possible outcomes: it goes up a lot, goes up a little, stays the same, goes down a little, or goes down a lot. With this revised model, a call buyer actually needs V to go up a lot, so now he has a 1-in-5 chance of being right, while the option seller has a 4-in-5 chance of being right. That’s all due to the premium paid or collected. Let’s look at some real numbers.

As I write this, V last closed at 230.14. This is beautiful because there’s a 230 strike available to trade. The closest expiration I have to 30DTE is 33DTE, and the 230 Call is pricing at 5.10 Bid vs. 5.85 Ask, so call the Midpoint 5.48. When our buyer enters into this contract with the seller, he has to pay her $5.48 per share for the right to buy V at 230 any time in the next 33 days. If exercised, the buyer’s cost basis would be 235.48 per share, and not just 230. So he really needs V to be trading above 235.48 by expiration in order to not lose money on this trade. This illustrates how the stock price can go up a little, but the call buyer still loses money. (And actually, going up 5.48 from 230 is 2.3% in 1 month, which is actually kind of a lot: about 27% per year.)

Conversely, the call seller gets to subtract the premium from the strike price, and that’s the breakeven point at which she starts losing money. V can be trading at 230 – 5.48 = 224.52 at expiration and the seller will break even. Any price below that and she loses money, but any price above she profits. So she profits in 4 of the 5 cases, just not when the stock price goes down a lot. Generally speaking, would you rather have limited risk but unlimited profit 20% of the time (as the buyer), or limited profit but (sort of) unlimited risk 80% of the time (as the seller)? It’s not as simple as that, of course, but I’d rather win more times than lose more times. Either can work, it’s just that one may fit your trading temperament better than the other.

Options are bets, pure and simple. Stocks are bets. Mutual funds are bets. Playing red at roulette is a bet. In all those cases we’re hoping for (betting on) a certain outcome. Above I talked about which side of options bets I prefer to take. Now let’s break it down as to whether an individual option at a given strike price, expiration date, and premium is a good bet for us to make or not.

Say our friend Dave owns 100 shares of V at 230 and he’s really afraid of it dropping in price by more than 10%, so he says to us, “If I gave you you $1.25 per share right now, could I sell my V stock to you at 205 any time in the next month?” Should we take that bet? What might we want to know first? Maybe the probability of V dropping 10% in any random 30-day period? Maybe: upcoming news that might affect the price of V; when the next earnings announcement is; what the unemployment trend is; what interest rates are doing. And maybe a ton of other things we feel like we’d want to know in order to decide on this bet. But you know what? “The market” has already priced all those things into the prices of Visa’s options; it’s an efficient market and all knowable information is priced in.

And one of the option Greeks, Delta, gives us an indication of the probability of this bet being favorable for us. I chose the numbers Dave proposed to us based on the 33DTE 205-strike Put option in the Visa option chain on ThinkorSwim (ToS). That 205P option has a Delta of 11, and is priced at a Midpoint of $1.25. Delta is kind of a stand-in for the probability of V hitting 205 in the next 33 days, and it’s telling us that there’s only about an 11% chance that it will. Knowing that, do we take Dave’s bet? Do we sell him a contract that says we’ll buy his hundred shares at 205 any time up to 33 days from now? I probably would, because the whole premise of my trading strategy is to sell options at about 10 Delta.

But there’s another number in ToS that I’ve come to appreciate more than Delta, and that’s Probability In the Money (“Prob.ITM”). I don’t know how they calculate it, but Prob.ITM tells us that this particular bet has a 13.0% chance of us losing. That’s not a large chance, right? Slightly worse than 8-to-1 odds. But when you consider that our downside risk is MUCH larger than the max profit of $1.25 per share, it might make us rethink it. (For instance, maybe V drops 20% on terrible news to 184; we’d have to buy Dave’s shares at 205, but they’re only worth 184, so we’d have an instant $21 per share loss. Compare that to the $1.25 per share he paid us to take that risk.)

So I’d say to Dave, “I won’t make that bet, but for $0.85 I’ll hedge your shares at 202.50.” (The 202.5 Put is at 8 Delta but only 9.7% Prob.ITM, and its Midpoint is 0.85.) 10% Prob.ITM or 10 Delta, whichever is the further-away strike, is kind of my comfort zone. I can’t really explain why, but it “feels right” to me. The odds are now 10 to 1, and I like that. You could pick any number you want. The higher you go in probability the more premium you’ll take in on each “bet”, but your trades will be challenged more and you’ll have to take more action to manage them and keep them profitable.

That’s the Put side of selling options, and I started there because it makes more sense to me from the seller’s side in that it goes back to the insurance analogy. On the Call side though, would our friend Dave ever say to us, “Hey, I’ll pay you money now to let me buy V from you a month from now for 10% more than it’s trading for today.“? I can’t really envision why an average Joe (or Dave) would do that. Why wouldn’t they just buy V stock now? There are certainly valid reasons to do that though, it’s just that it doesn’t make as much implicit sense as the insurance scenario does for Puts.

But regardless of why, there is a market that wants to buy Calls above a stock’s current price. Which is handy for us as sellers of strangles because we need to sell a Put below a stock’s price AND sell a Call above its price, thus “strangling” the price of the stock between the two options we’ve sold. The math and probabilities are all the same on the Call side as on the Put side. But where in our bet with Dave we were on the hook to buy his 100 shares of V at 205, on the Call side bet we’re obligated to sell him 100 shares of V at say 255. (Plus/minus $25 from 230 in either case.) So now if V has rallied up 20% and is trading at 276, we have to buy shares at that price then turn around and sell them to Dave at 255. Same $21 loss per share as on the Put side when the stock dropped 20%.

We could make either or both of those bets with Dave against his V stock, but it’s not likely he’s going to want to do both. So maybe we bet with him on the Put side, then later bet with someone else still on V stock on the Call side. And we just keep doing that: “insuring” either the downside or the upside of V with whoever wants to make that bet with us. Either bet will work out for us in the long run if we make it enough times, because of … reasons. (Having to do with option pricing based on Implied Volatility almost always over-estimating actual volatility.)

When we made that initial Put bet with Dave, even though we collected from him real cash-money dollars, our broker ALSO set aside some of the dollars already in our account to cover a portion of the risk we took on in making that bet. Whatever algorithms they use (and they’re based on probabilities), the broker said, “Your bet with Dave is this risky [insert BPR], so we’re going to hold some of your account hostage as collateral until the bet is over.” And that’s totally fair, and actually gives us a basis to sort of “monetize” our assumed risk.

But here’s where it gets fun, and why I like short strangles so much, compared to just playing one side or the other. While we have that bet on with Dave that V will go down 10% in the next month, if Joe comes along and wants to bet us that V will go up 10% in the next month, our broker says, “Meh, both bets can’t be right at the end, so you know what? We’re only going to hold one bet’s worth of BPR as collateral while you have both bets on.” How cool is that?? If you don’t know: it’s VERY cool.

Because you could sell naked Puts (or even safer, cash-secured Puts) all day long and make good money, but now your broker says, “Why don’t you go ahead and sell a Call too, and we’ll use the same collateral to cover both trades.” Why is that so cool, you wonder? Because it essentially doubles your return on investment! You earned a Credit/Premium when you made the Put bet with Dave, and your broker held some of your account as collateral. But then you made the opposite bet with Joe and your broker covers it with the same collateral because he knows you can’t lose both bets. So when you divide Credit by BPR to get the ROI of either a Put or Call trade, now you essentially get to double the Credit, so your ROI doubles. It’s like free money; or rather, extra money earned on capital already at risk. In short, it’s beautiful.

In theory, if you choose the Put and Call each at about 10 Delta, then the risk of either side of the trade is about the same and the BPR for either should be about the same. In practice, one side of the strangle or the other will require more collateral, so your broker will hold the higher collateral requirement. That then covers you making the opposite trade using that same collateral. It’s kind of like the “buy one, get one of equal or lesser value free” promotions.

The double-the-Credit thing is great, but the other reason I love short strangles is because you can easily adjust the naked Put and Call strikes when they get challenged or breached. That should happen only 10% of the time or less, but now that I’ve dealt those situations many times I’m no longer afraid of them. The reason is that you can almost always move Puts or Calls inward (toward the stock price) for more credit, or move them outward in exchange for more time. My <Trade Log> has examples of both of those repair strategies.

I only really understood this concept when I saw it in action for myself. Set yourself up a paper-trading account at TDA (or elsewhere), or just set up 1-lot trades that don’t cost you too much and see for yourself. Put on Put Credit Spreads with the narrowest possible spread between the bought Put and the sold Put. Eventually the stock price will move against one of them, first touching the sold (short) Put, then breaching it, then touching/breaching the bought (long) Put. Try to figure out a way to move the Puts within the current expiration for a credit, or move them out to a later expiration for a credit. You’ll almost never be able to. It’s the interaction between the short and long Puts increasing in value at different rates that gets you.

Try the same thing with Call Credit Spreads. You’ll get the same result. Now marry those two strategies and build yourself some Iron Condors and wait until one of them gets breached on the high or low side. Not only will you find that you can’t do anything with the credit spread that’s been breached (you proved that when you were selling just Put spreads or Call Spreads), but you’ll ALSO find that you can’t even “roll in” the untested side because of the long option that’s fighting against the short option you’re trying to buy back and then sell for more Credit.

Now take one of those Iron Condors and lop off the long options, the “protective” wings. What do you end up with? A Short Strangle! Now it gets fun, even easy. Did the stock drop in price and is now close to the short Put? Simply buy back the short Call and re-sell it closer to the stock’s current price. You’ll bring in more Credit, which when you add to the initial Credit you get to subtract all that from the Put strike to give yourself an even lower Break Even (BE) Point.

Is the stock’s price at or slightly below the Put? Roll the Call all the way down to equal to the Put price. You’ve built a Short Straddle and will take in a LOT of Credit, maybe even more than the initial Credit. Now plot what your lower BE looks like. You’ll see that the stock can move a good bit lower before you start actually losing money. (And of course you can do both of these adjustments on the Call side: roll up the Put, or build a Straddle at the Call strike.)

What if the stock price keeps dropping and you have several days till expiration? Roll out in time for more credit. Try keeping the Straddle strikes (if you got to that point) and roll out just a week and see how much credit you get; it should be substantial. But what I like to do is try to re-center the stock price between the Put and Call strikes, ideally at 10-delta. They say you should never roll for a debit, and I mostly agree with that, so any time you roll try to take in more credit. If you’re staying in the same expiration and rolling only one of your options up or down toward the stock price you should always get a Credit. If you’re keeping the same strike prices on the Put and Call and rolling out in time, you should always get a Credit.

It’s only when you change expiration weeks AND strike prices that you’ll have to balance things out so you get a Credit. Play around with it and you’ll get a feel for it. You likely won’t be able to re-center the stock’s price between 10-delta strikes in the next expiration week and still get a Credit, buy you might be able to put you strikes at 30-delta on each side and get a credit. Or maybe 20-delta two weeks out. But as long as the company remains solvent, you should always be able to adjust a strangle to be profitable in the end. You can’t say that about Credit Spreads or Iron Condors, or probably any other trade that’s a combination of a long option with a short option.