By Zachary Scheidt on September 30, 2014

Some of the most frustrating periods for active traders can be those times when markets are relatively flat. A material amount of price action higher or lower can provide enough movement for a skilled trader to make money. But if equities are in a holding pattern, profit opportunities can be relatively constrained.

One strategy for creating profits during quiet periods is known as a short option strangle.

To set up this trade, we would sell an out-of-the-money call option and an out-of-the-money put option with the same expiration date. The idea is to create a scenario where we can capture time premium from two different option contracts while waiting for the market environment to change.

The maximum gain is the option premium we receive upfront from selling the calls and the puts. We will get to keep that income as long as the stock stays between the strike prices of the two options.

Let’s walk through an example to illustrate the short strangle.

Consider a $50 stock that is trading in a relatively tight range. We might consider selling a $55 strike call that expires in three months and a $45 put with the same expiration date.

Since we are targeting stocks with a low level of volatility for this strategy, we can’t expect to receive a huge amount of income. But selling two option contracts can give us the extra cash necessary to make the trade worthwhile on a risk-adjusted basis.

Let’s assume we could sell the call and put options for $0.50 apiece, generating $1 per share ($100 per option contract, which controls 100 shares).

Your upper breakeven would be equal to the call’s strike price plus the net credit generated when you entered the trade ($55+$1 = $56). The lower breakeven would be equal to the put’s strike price minus the net credit ($45-$1 = $44).

In this case, if the stock rallies by less than 10% or declines by less than 10% in the time to expiration, we will make the maximum expected profit from the trade.

However, if the stock trades below $45 and the puts are exercised, we will be obligated to buy shares at $45. Our net cost will actually be $44 because of the $1 in option premium we received. So, anything above this price will mean we still have a profitable trade on our hands.

Conversely, if the stock rallies and is trading at $55 on expiration, the puts will expire worthless, but the call will be in the money. Here our loss is equal to the price of the stock minus the strike price of the short call minus the net premium received. So, if our stock trades to $58, we will have a loss of $200 per contract.

Position Management

When using a short strangle to create income in a flat market, it is important to understand the potential risk. This strategy is considered a short volatility approach, which means that an increase in volatility can result in a negative return. In fact, without proper management, the losses can theoretically be unlimited.

We need to have a plan in place for what to do in the event the stock breaks out of the current range. Regardless of whether it trades materially higher or lower, a significant breakout or breakdown will cause us to be long a falling stock or short a rising stock.

One strategy for mitigating this risk is to place a buy stop order above the stock’s current range and to place a sell short stop order below the range. This way, if the stock trades materially below the strike price of the put contract, we will automatically enter a short position to offset our risk. Alternatively, if the stock trades materially above our call strike price, we will automatically purchase shares to offset our risk.

If either of these stop orders is executed and the stock remains outside of the range (above the call strike price or below the put strike price), our position will ultimately be closed out by the option contract being exercised against our stock position.

While this approach can be very helpful in avoiding a loss from a runaway stock, we must be aware of how the stock continues to trade until the position is fully closed. In the case where we buy stock to offset our call position, the stock exposure now gives us a risk of loss if it trades back below the call strike price.

The opposite scenario where we are short puts and short stock can also introduce a new risk if the stock rebounds against our equity short position. So while this strategy can help generate income during calm market periods, it is important to quickly adjust to a spike in volatility.

This Strategy Works for Panic Periods Too

Selling calls and puts can be an excellent strategy for periods when the overall market (or one stock in particular) has sold off sharply and is fairly washed out. At times like this, high levels of volatility cause option prices to be inflated.

For instance, a stock that has declined from $100 to $50 may very well pay us $3 per share for selling three-month $45 puts and $55 calls. This means that we could theoretically collect $6 per share in premium, expanding our profit opportunity on the stock to a range of $39 to $61.

Timing is very important when using this strategy for a washed-out market. If you sell the option contracts too early, the stock could continue to fall and quickly accumulate losses. But the inflated premium levels for the option contracts can help to mitigate this risk by giving us a much wider range of potential profitability.

One thing to keep in mind is that bear market rallies can be swift and severe. So be particularly aware of the possibility of a sharp rebound in the stock. It may make sense to place a buy stop very near the call’s strike price so that, if a rebound occurs, you will have bullish exposure at a lower entry point, thus remaining profitable even though you are short the calls.

Note: If you’re interested in using options to generate income, my colleague Amber Hestla has closed 66 straight winning trades using a put selling strategy. See her first 52 winners and learn exactly how you can make the same profitable trades by following this link .