Is selling strangles profitable?
Today, let’s take a look at the research from Pepperdine University professor Clemens Kownatzki & Claremont Colleges professor Hisam Sabouni.
Professors Kownatzki & Sabouni explore selling equity insurance in their paper: ‘Option Strangles: An Analysis of Selling Equity Insurance’
They found; “Our results suggest, selling SPY strangles are generally profitable across a variety of widths. However, the payoff profile of a short option strangle exposes the contract seller to a potential for unlimited losses.”
Firstly, what is a strangle?
An equity option strangle is a trading strategy used by investors to profit from a significant movement in the price of a stock. It involves buying both a call option and a put option on the same stock with the same expiration date, but at different strike prices.
The idea behind a strangle is that it allows an investor to profit from a large move in the price of the underlying stock, regardless of whether it moves up or down. By purchasing both a call option and a put option, the investor has the right to buy or sell the stock at the strike prices of the options, regardless of the direction of the stock’s movement.
For example, let’s say an investor buys a call option with a strike price of $50 and a put option with a strike price of $40 on a stock that is currently trading at $45. If the stock price moves significantly in either direction, the investor will profit. If the stock price goes up to $60, the investor can exercise their call option and buy the stock at the strike price of $50, then sell it for a profit. On the other hand, if the stock price drops to $30, the investor can exercise their put option and sell the stock at the strike price of $40, then buy it back at the lower market price for a profit.
An equity option strangle is considered a high-risk, high-reward trading strategy. As a result, requiring a significant movement in the stock price to be profitable. However, it can be a useful tool for experienced investors who are looking for a way to profit from market volatility.
The professors also go on to find; Our evidence on maximum draw-downs indicates that losses on some positions can be the equivalent of the profits gained on approximately forty prior positions. This payoff profile has given rise to the metaphor of selling option contracts as the equivalent of “picking up nickels in front of a steam roller.”
According to the proffesors, the aim of the work was; “to analyze the full return characteristics of option strangles and to develop a set of models to help investors avoid getting steam-rolled. As a result, we forecast the likelihood of profitability of SPY strangles. We use information that is available at the time a position is under consideration to attempt to avoid strangle positions with potentially large losses.”
Download the full paper:
Is selling strangles profitable?
