Short Straddle Options Strategy

Submitted by admin on Thu, 11/25/2021 - 23:24

This technique entails selling both call and put options with the same expiration date and strike price.

Description


A short straddle is a combination of writing naked calls (bearish) and naked puts (bullish), both with the same strike price and expiration date.
They create a position that forecasts a tight trading range for the underlying stock when combined.


Prior to the introduction of options, it was impossible for investors to benefit directly from a correct forecast that did not include a sharp rise or fall in the underlying stock.
The short straddle is an illustration of a method that does this.
By receiving two upfront premiums, the investor establishes a bigger margin of error than if he or she only wrote a call or a put option.
However, if a major move occurs, the risks are huge on the downside and limitless on the upside.


The investor may be able to minimize the risk of assignment by choosing a longer time to expiry, actively watching the underlying stock, and being prepared to move quickly.
No precautionary measure, however, can alter the fundamentals: finite rewards for boundless risk.

 

EXAMPLE

  • Short 1 AAPL 160 call
  • Short 1 AAPL 160 put

 

GAIN MAXIMUM


Premium obtained


LOSSES ARE LIMITED TO THE MAXIMUM


Unlimited


Outlook


The approach anticipates a stable stock price during the option's term and an equal or decreasing amount of implied volatility.


Due to the high possibility that the stock price would deviate from the predicted trading range, the view regarding the stock's near-term stability is likely to be rather strong.

Summary


This technique entails selling both call and put options with the same expiration date and strike price.
It normally gains when the stock price and volatility of the underlying asset stay stable.

Motivation


Earn money by selling premiums.

Variations


A short straddle is constructed on the assumption that both the call and put options have the same strike price.
For a variation on the same approach with a higher call strike and a lower put strike, see the debate under short strangle.


Additionally, a cautious but bullish stockowner might lower an existing long stock position while simultaneously writing an at-the-money short straddle, a technique referred to as a protected straddle or covered straddle.
For a more in-depth examination of this topic, see covered strangling.

Maximum Loss


The danger is limitless.
The worst-case scenario is for the stock to reach infinity, while the second-worst-case scenario is for the stock to sink to zero.
The loss in the first scenario is indefinitely huge; in the second situation, the loss equals the strike price.
In either case, the loss is offset by the premium revenue earned on the options sold.


If the stock price exceeds the strike price of the call, the investor is assigned and so compelled to sell the shares at the strike price and purchase it on the market.
If the stock price falls below the put strike price, the investor is assigned and so forced to purchase the stock at the strike price, regardless of the reduced market value.
That implies either selling it in the market at a loss or holding a stock that is more expensive than its present market worth.

Maximum Gain


The maximum gain is restricted to the initial premiums earned.
The best-case scenario is for the stock price to be exactly at the strike price at expiry.
Both short options will expire worthless in this situation, and the investor will retain the premium obtained for selling the options.

Profit/Loss


Profitability is quite restricted.
In the ideal case, the short positions are maintained until expiry, the stock closes exactly at the strike price, and both options expire without being assigned.
The investor then retains both the call and put premiums.


Any alternative consequence entails being assigned to cover one or both sides of the straddle, or being compelled to do so.
The overall effect, depending on the stock price, will be either a reduced profit or a loss.
Although the 'dual' premiums earned at the beginning provide some margin for error if the stock moves in either way, the possibility of massive losses remains.

Breakeven


This approach is profitable if the stock price is above or below the strike price by the amount of premium income earned at expiry.
At either of those levels, the intrinsic value of one option will match the premium obtained for selling both options, while the other will expire worthless.


Breakeven point on the upside = strike plus premiums received


Breakeven point on the downside = strike - premiums received

Volatility


Extremely critical.
The probability of success of this technique would increase if implied volatility decreased.
If the stock price remains stable and implied volatility declines rapidly, the investor may be able to profitably exit the position well before expiration.


On the other hand, if implied volatility unexpectedly increases, the effect on this approach is quite unfavorable.
The likelihood of the underlying going over the breakeven point appears to be increasing (at least in the market's perspective), and as a result, the cost of closing out the straddle also increases.
It may compel the investor to sell at a loss in order to avoid more losses.

Time Deterioration


Significantly beneficial effect.
Each day that passes without an increase or decrease in the underlying stock price pushes both options closer to expiration, which is obviously the investor's best-case scenario.

Assignment Danger


While early assignment is feasible at any time, it is more risky in particular situations: for a call, shortly before the stock goes ex-dividend; for a put, when the stock is deeply in the money.
However, because the short straddle contains two short legs that are subject to assignment at any moment throughout the option's life, investors should watch the possibility of assignment.


Additionally, bear in mind that a circumstance in which a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off, or special dividend, may radically deviate from usual expectations for early exercise of stock options.

Risk of Expiration


The investor will not know for certain whether they were assigned or not until the Monday after expiry.
It is also possible for both options to be assigned if the stock trades barely above or below the strike price on the day before expiry.
The investor would need to plan for a variety of scenarios, including being assigned to one or both options, both, or none.
There is no certain method to 'cover' all possible outcomes, and predicting incorrectly might result in an unexpected long or short stock position the following Monday, dependent to the stock's weekend performance.


Close monitoring and allocating resources to manage all possible outcomes are one method to prepare for this risk; the other is to close the straddle out early.


This technique is essentially a race against time decay and volatility.
Volatility is the storm that may blow in at any time and produce catastrophic losses, or it could never come at all.
Each passing day puts the investor a bit closer to receiving the anticipated profit.


Take note that this position is a combination of a naked call and a naked put.