Short Straddle Strategy Explained
A short straddle is an options strategy used when an investor expects very little movement in the price of the underlying asset. It involves selling a call option and a put option with the same strike price and expiration date.
How it works: By selling both options, the trader collects premiums upfront. The maximum profit is limited to the total premium received, and this occurs if the underlying asset closes exactly at the strike price on expiration.
The goal is to profit from little or no price movement in the underlying stock.
Risk profile: While the potential profit is capped, the potential losses are theoretically unlimited if the price rises significantly, or substantial if it falls sharply.
- Profit potential is limited to the total premiums received less commissions.
- Potential loss is unlimited if the stock price rises and substantial if the stock price falls.
Because of this, the short straddle is considered a high-risk strategy.
When it’s used: Traders typically deploy short straddles when they expect very low volatility and believe the asset’s price will remain close to the strike price during the life of the options.
In short, the strategy profits from stability but can be severely impacted by unexpected market moves. It is generally suited only for experienced investors who are comfortable managing significant risk.
Appropriate market forecast
A short straddle profits when the price of the underlying stock trades in a narrow range near the strike price.
The ideal forecast, therefore, is “neutral or sideways.” In the language of options, this is known as “low volatility.”
Strategy discussion
A short – or sold – straddle is the strategy of choice when the forecast is for neutral, or range-bound, price action. Straddles are often sold between earnings reports and other publicized announcements that have the potential to cause sharp stock price fluctuations.
It is important to remember that the prices of calls and puts – and therefore the prices of straddles – contain the consensus opinion of options market participants as to how much the stock price will move prior to expiration. This means that sellers of straddles believe that the market consensus is “too high” and that the stock price will stay between the breakeven points.
“Selling a straddle” is intuitively appealing to some traders, because “you collect two option premiums, and the stock has to move ‘a lot’ before you lose money.” The reality is that the market is often “efficient,” which means that prices of straddles frequently are an accurate gauge of how much a stock price is likely to move prior to expiration. This means that selling a straddle, like all trading decisions, is subjective and requires good timing for both the sell (to open) decision and the buy (to close) decision.
Impact of stock price change
When the stock price is at or near the strike price of the straddle, the positive delta of the call and negative delta of the put very nearly offset each other. Thus, for small changes in stock price near the strike price, the price of a straddle does not change very much. This means that a straddle has a “near-zero delta.” Delta estimates how much an option price will change as the stock price changes.
However, if the stock price “rises fast enough” or “falls fast enough,” then the straddle rises in price, and a short straddle loses money. This happens because, as the stock price rises, the short call rises in price more and loses more than the short put makes by falling in price. Also, as the stock price falls, the short put rises in price more and loses more than the call makes by falling in price. In the language of options, this is known as “negative gamma.” Gamma estimates how much the delta of a position changes as the stock price changes. Negative gamma means that the delta of a position changes in the opposite direction as the change in price of the underlying stock. As the stock price rises, the net delta of a straddle becomes more and more negative, because the delta of the short call becomes more and more negative and the delta of the short put goes to zero. Similarly, as the stock price falls, the net delta of a straddle becomes more and more positive, because the delta of the short put becomes more and more positive and the delta of the short call goes to zero.
Impact of change in volatility
Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices – and straddle prices – tend to rise if other factors such as stock price and time to expiration remain constant. Therefore, when volatility increases, short straddles increase in price and lose money. When volatility falls, short straddles decrease in price and make money. In the language of options, this is known as “negative vega.” Vega estimates how much an option price changes as the level of volatility changes and other factors are unchanged, and negative vega means that a position loses when volatility rises and profits when volatility falls.
Impact of time
The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion, or time decay. Since short straddles consist of two short options, the sensitivity to time erosion is higher than for single-option positions. Short straddles tend to make money rapidly as time passes and the stock price does not change.