Benefit from the straddle option strategy
Essentially, the short straddle involves selling both a short call and a short put of the same strike price in the same expiration series. The short straddle option strategy is a neutral options strategy that capitalizes on volatility contraction, theta decay, and minor up or down movements in the underlying asset. Anticipating very little movement in the underlying, is the primary reason to implement the short straddle option strategy. Short straddles will be more sensitive to volatility contraction, expansion and theta decay. This is because short straddles are typically traded at or around the money.
Short Straddle Option Strategy Definition
We sell option to receive options premium. A Straddle is an excellent option strategy to do this. How do you set up a short straddle:
- Sell 1 call (same strike price) around 45 DTE
- Sell 1 put (same strike price) around 45 DTE
A straddle is called an undefinde risk strategy. Most of the time the risk is within 2 standard deviation.
Short Straddle Example
Stock XYZ is trading at $50 a share.
- Sell 50 call for $0.70
- Sell 50 put for $0.70
The net credit received for this trade is $1.40 ($140), the premium from both short options positions.
The best case scenario for a short straddle is for the underlying instrument not to move at all. If stock XYZ stayed at $50 until expiration, this trade would be fully profitable.
Typically, short straddles are traded at the money or very close to it, but they technically don’t have to be. As long as both the short call and the short put are the same strike price, it is considered a short straddle.
When to sell a short Straddle
What is the best time to sell a straddle? When a company is about to announce their results investors get excited. In response of this sentiment option prices will rise. If volatility is still high after the announcement you can sell option premium. It is most likely that the volatility will drop and that you can close the position for a profit.
Maximum Profit and Loss for Short Straddle
Maximum profit for a short straddle = the PREMIUM RECEIVED
Maximum loss for a short straddle = in theory it could be UNLIMITED.
The maximum profit for a short straddle is always the total sum of the premium received. In the case of XYZ, it’s $140.
The maximum loss is not so appealing. For the short call portion of a short straddle, the max loss is theoretically unlimited. If stock XYZ goes to $100 a share, the short call will be a massive loser. Conversely, if XYZ goes to $0 a share, the short put will be a massive loser, but the loss is defined for the short put. In general stocks does not move much more than 1 Standard Deviation.
Therefore, the ideal situation for the short straddle option strategy is that the underlying does not move at all and have volatility contract dramatically. Short straddles are highly effective to express a very neutral market opinion or a bearish opinion on volatility.
Break-Even for a Short Straddle
The short straddle break-even has both an upside and a downside.
For the downside, the break-even = the straddle strike – the premium received.
For the upside, the break-even = the straddle strike + the premium received.
How to profit from a short straddle?
We discuss premium decay. When the underlying only moves slightly the option premium will get smaller with the passage of time, this is known as theta decay. Another way you can benefit is when volatility contracts.
Premium is priced out of ATM options faster than ITM options, so short straddles greatly benefit from time decay. Both legs of the trade, the short call and the short put, are beneficial to theta decay.
Important Tips for Short Straddles
Traders should use additional caution when trading short straddles, as it is an undefined risk trade. Although the trade will be delta-neutral open order-entry, large moves in either direction in the underlying can cause significant losses.
Best stocks for straddle option position is stocks that does not move much.
Large movements either up or down will significantly harm the position. This is why selling straddles is a common tactic for large low-beta indices that don’t move as much as individual stocks, i.e. SPX. Some ETFs are popular underlying asset choices as well, like SPY.
This options strategy should be managed aggressively. Take the risk of the table as soon as you can make 25% profit by closing the position.