Short Straddle

From CEOpedia | Management online

A short straddle is the simultaneous sale of a call and a put on the same stock with the same strike price and expiration month. An option investor would sell a straddle when he or she expects the stock price to trade within a narrow range or to become less volatile and not to make a significant move in either direction. An investor who is short on straddle is neither bullish nor bearish. The investor is not concerned with whether the stock moves up or down in price, so long as it does not move significantly. An investor may sell a straddle just after a period of high volatility, with the belief that the stock will now move sideways for a period of time[1].

Trading strategy

The short straddle involves selling a call and put option with the same strike and same expiration[2]. A short straddle is a trade for highly speculative traders who think a security will trade within a defined range and that implied volatility is too high. As adverse deltas get bigger because of stock price movement, traders have to be on alert, ready to neutralize directional risk by offsetting the delta with stock or by legging out of the options. To be sure, with a short straddle, every stock trade locks in a loss with the intent of stemming future losses[3].

Risks with short straddles

A short straddle may sometimes lead to a false sense of comfort - sometimes it looks as if short straddles need a big move to lose a lot of money. Because of its potential - albeit sometimes small potential - for a colossal blowup, the short straddle is one of the riskiest positions one can trade. It has a place in the arsenal of option strategies for speculative traders[4].

Differences with a long straddle

Short-straddle traders must take a longer-term view of their positions than long-straddle traders. While a long straddle needs to be actively traded, a short straddle needs to be actively monitored to guard against negative gamma. Often with short straddles, it is ultimately time that provides the payout. There are different factors that need to be focused[5]:

  • long straddle traders would be inclined to watch how much movement is required to cover each day's erosion,
  • short straddlers are more inclined to focus on the at-expiration diagram so as not to lose sight of the end game.

Short straddle example

A trader, John, has been watching Federal XYZ Corp (XYZ) for a year. During the 12 months that John has followed XYZ, its front-month implied volatility has typically traded at around 20 percent, and its realized volatility has fluctuated between 15 and 20 percent. The past 30 days, however, have been a bit more volatile. The stock volatility has begun to ease, trading now at a 22 volatility compared with the 30-day high of 26, but still no down to the usual 15-to-20 range. The stock, in this scenario, has traded in a channel. It currently lies in the lower half of its recent range. Although the current front-month implied volatility is in the lower half of its 30-day range, it's historically high compared with the 20 percent level that John has been used to seeing, and it's still four points above the realized volatility. John believes that the conditions that led to the recent surge in volatility are no longer present. His forecast is for the stock volatility to continue to ease and for implied volatility to continue its downtrend as well and revert to its long-term mean over the next week or two. John sells straddles. The goal here is for implied volatility to fall around 20 - if it does, John makes profit[6].

Advantages of Short Straddle

A short straddle is a popular trading strategy for investors who are not particularly bullish or bearish on a particular stock, and expect the stock to remain relatively stable over a given period of time. This strategy offers several advantages, including:

  • Limited Risk: Short straddles involve limited risk, since the investor only has to pay the initial cost of the options, and will not suffer any further losses if the stock’s price remains unchanged.
  • Potential for Profit: Short straddles also offer potential for a profit, since the investor can benefit from any decrease in volatility of the stock and benefit from a decrease in the option’s price.
  • Flexibility: This strategy also offers flexibility, since investors can decide when to close out their position and take any profits or losses.
  • Low Capital Requirements: Finally, short straddles require relatively low capital requirements, since only the cost of the options needs to be paid up front.

Limitations of Short Straddle

A short straddle is a strategy that can be used to profit from a stock that has low volatility or has the potential to remain range-bound. However, this strategy does come with several limitations. These include:

  • Limited Profit Potential: Selling a straddle means that the investor is selling both the call and put options, and in both cases, the potential gains are limited to the premiums received for selling the options.
  • Unlimited Risk: The risk of a short straddle is unlimited due to the potential for the stock to move significantly in either direction. If the stock moves higher, the call option has unlimited upside potential, and if the stock moves lower, the put option has unlimited downside potential.
  • High Margin Requirements: The margin requirements for short straddles are typically higher than other strategies, as the investor must have sufficient capital in their account to cover the full cost of both options.
  • Time Decay: Time decay is an issue with short straddles, as the time value of the options will decrease over time. This means that, over time, the investor will need to close the position or risk losing money as the options become less valuable.

Other approaches related to Short Straddle

A short straddle can be combined with other approaches to provide an investor with a more sophisticated trading strategy. Here are some of the other approaches related to short straddle:

  • Covered Calls: This is a strategy where the investor buys the underlying stock and then sells a call option on the same stock. The goal is to generate income from the option premium and benefit from any appreciation of the stock price.
  • Protective Put: This is a strategy where the investor buys the underlying stock and then buys a put option on the same stock. The goal is to protect against any losses in the stock price and benefit from any appreciation of the stock price.
  • Ratio Spreads: This is a strategy where the investor buys one option and sells a number of other options with different strike prices and expiration dates. The goal is to benefit from the time decay of the options sold and the movement of the underlying stock.

In summary, there are several approaches that can be combined with a short straddle to generate income and protect against losses in the stock price. Each strategy has its own unique risk-return profile and should be evaluated on an individual basis.


Short Straddle — recommended articles
Gamma hedging — Rolling Option — Short call option — Options — Uptrend — Blue chip — Bunny Bond — Selling Into Strength — Bull flag

References

Footnotes

  1. ↑ The Securities Institute of America, Inc., 2016, p32
  2. ↑ Rhoads, R., 2011, p146
  3. ↑ Passarelli, D., 2012, s295
  4. ↑ Passarelli, D., 2012, s295
  5. ↑ Passarelli, D., 2012, s295
  6. ↑ Passarelli, D., 2012, p296

Author: Gabriela Sambór

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