Anatomy of a Short Choke

If inflated option premiums have you considering the short side of volatility, a recent episode of Best Practices might be for you.

This episode focuses on short chokes and the factors that contribute to P/L.

A choke is constructed by trading two different options (a put and a call) with different strikes, but within the same expiration period. When deploying a long choke, both options are bought, while a short choke involves selling both options.

The intensity of the risk profile of a given bottleneck is generally dictated by the delta of the options used in its construction. Higher delta options imply higher premiums, meaning there is more at stake the closer to the currency (ATM). At the same time, strikes further away from the current underlying price can also be breached, albeit with a lower probability.

Generally speaking, stranglehold sellers hope that the underlying price stays between the two stranglehold strikes until expiration, and that the implied volatility decreases. A strange buyer hopes otherwise.

The maximum gain for a choke seller is the total credit received during commercial deployment, while the theoretical maximum loss is unlimited. On the other hand, the maximum theoretical gain for a stranglehold buyer is unlimited, while the maximum loss is limited to the total premium spent on the position.

Strike selection in chokeholds involves a balance of risk and reward, and should match your own unique risk thresholds. It is important to keep in mind that as you move away from the ATM, the potential reward (credit received) also decreases.

On best practices, the hosts discuss the three main factors that dictate the P/L of a choke:

Depending on the position taken, strangle traders will look for a certain behavior in the options and the underlying stocks, per the bullet points above.

For bottleneck sellers, a lack of movement in the underlying should unleash the power of time decay (aka theta collection). A moderate movement in the underlying should also result in lower implied volatility, although this is not always the case.

On the other hand, a large movement in the underlying theoretically benefits stranglehold buyers, especially if the price breaks above one of the strike prices. The increase in implied volatility can also benefit a long squeeze, even if the underlying is not moving.

The slides below, taken from best practices, illustrate the mechanics of a short choke and the preferred paths to positive returns:

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It should be added that the credit received from the sale of a short strangle will act as a buffer to some extent, especially if the underlying price goes through one of the strikes. A short choke will break even if the underlying price breaks out of one of the strike prices by the same amount as the credit received.

Using the example from the slides above, this means that this particular short bottleneck will break even if the underlying price closes at $88.50 or $106.50. Anywhere inside this range represents a profit, and anywhere outside this range represents a loss.

We hope you’ll take the time to review the entire best practices episode focused on short-lived chokes when your schedule allows. If you want to learn more about the potential pitfalls of short chokes, we also recommend this article on market metrics.

If you have any outstanding questions about chokes or any other trading-related topic, we hope you’ll leave a message in the space below or contact us directly at [email protected]

We look forward to hearing from you!

Sage Anderson has extensive experience in trading equity derivatives and managing volatility-based portfolios. He has negotiated hundreds of thousands of contracts across all industries in the single-equity universe.

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