Option Investor
Educational Article

Credit (Short) Strangle

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The derivatives market is unique because it offers a variety of ways to be successful. Although the majority of participants are comfortable with simply buying calls and puts, the difficulties involved in profiting from long positions in directional plays compels many traders to use a more unbiased approach. In the last segment, we examined one of the most popular strategies in this group; the debit straddle. However, there is another favorable technique in the delta-neutral category and because it based on short option positions, it does not suffer from the effects of time-value erosion.

Historically, the option writer enjoys profit potential that is more consistent than any other segment of derivatives trading. Through the sale of options, the disciplined player can easily generate returns of 50-75% annually, in all types of market conditions. The strategy of writing options also offers a higher success ratio than other trading techniques because the odds are stacked in your favor. The reason is simple; using this approach is similar to being the "house" in a casino. The house gladly takes the bets of players in the casino because they always have a mathematical advantage over the gaming customer. Traders who sell options are in a similar position as they take the place (and the advantage) of the market-maker, providing additional liquidity for other retail participants. Since option writers are essentially selling time, they have the benefit of a statistical edge because the "premium" in options erodes with every passing day. This advantage allows the option writer to profit in a high percentage of positions, even when the underlying issue does not move as expected. Traders who sell out-of-the-money options have an even bigger edge, as only the most adverse activity will result in a losing transaction. That concept is the fundamental basis for the use of the credit (short) strangle.

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