Short Straddle

Short Straddle
See also
Uptrend Gravestone doji Bearish divergence Three white soldiers Long-legged doji Gamma hedging Bull flag Long Hedge Three Black Crows

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.

Trading strategy

The short straddle involves selling a call and put option with the same strike and same expiration. 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.

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.

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:

• 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.

References

• Passarelli, D., (2012), Trading Option Greeks. How Time, Volatility, and Other Pricing Factors Drive Profits. Second Edition, John Wiley & Sons, Inc., Unites States of America
• Rhoads, R., (2011), Option Spread Trading. A Comprehensive Guide to Strategies and Tactics., John Wiley & Sons, Inc., Unites States of America
• The Securities Institute of America, Inc., (2016), Wiley Series 9 Exam Review 2016 + Test Bank: The General Securities Sales Supervisor Qualification Examination - Option Module, John Wiley & Sons, Inc., Unites States of America

Footnotes

Author: Gabriela Sambór