What is a Short Straddle
As opposed to it's high volatility counterpart, the long straddle, the short straddle is a high risk, low volatility, limited return options strategy. The short straddle involves selling one at the money call and put short at the same strike price and expiration date with the expectation that the stock will remain relatively neutral until the expiration of both options. The short straddle is a play on the time decay, or theta, of an option.
Short Straddle Risk Characteristics
As you can see on our chart below, as long as the stock remains between the two breakeven points at expiration, the trader will remain in a profit position. Once the stock moves past either one of these boundaries, the losses are unlimited, especially to the upside. The maximum downside risk in a stock is when it moves to 0. The upside potential is theoretically limitless.
Let's review the risk parameters, breakeven prices, and profit potential of this strategy.
Options strategy - Short Straddle
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Breakeven on the Downside (*b1) = Strike Price - Call Premium - Put Premium
Breakeven on the Upside (*b2) = Strike Price + Call Premium + Put Premium
Risk = Unlimited on when stock moves above or below breakeven points.
A short straddle will always have a maximum profit potential equaling the premiums received from selling the straddle
Maximum Profit Potential = Call Premium + Put Premium
For more precision, we can use the following formula to determine the gain or loss at expiration.
Profit/Loss at Expiration = Call Premium + Put Premium - Absolute Value(Security Closing Price - Strike Price)
Short Straddle Trading Example
To illustrate an example of a short straddle, I will use UYG (Ultra Financial Pro Shares Double Leveraged ETF) which is currently trading at $9.94, close enough to the $10 strike that we will use for this example.
Call Option Chain:
Put Option Chain:
UYG is trading at $9.94 as of today's close, close enough to our 10 strike and we will go out till March 2009 for this example. The implied volatility in the options chains above is extremely high, as evidenced by the VIX index which is hitting historical extremes, due to the financial crisis that has gripped our economy and therefore, this strategy can prove to be quite profitable if the volatility calms down.
To initiate the short straddle, we would sell the 10 put at $2.65 and sell the 10 call for 2.80, for a net credit of $5.45. Based on our breakeven calculations above, this would mean that UYG would have to stay between $4.55 and $15.45 for this trade to remain in a profitable position. The downside risk in this trade is $4.55 per share (if UYG goes to 0) and the upside risk is unlimited.
To hedge the unlimited risk to the upside, traders may elect to put in a buy stop order if the price breaks above the upper breakeven point. This will prevent the trader from suffering exponential losses on the short call option. Conversely, if the stock starts to drop below $4.45, the trader may elect to short the stock to hedge the downside.
The play here is theta decay and therefore, you want to make sure that volatility is low for this trade to have the best chances of being profitable. The current volatile trading environment does not bode well for a strategy such as the short straddle.
Related Topics
Options strategies:
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