This is the video tutorial for the short straddle options strategy. As we get into it here, the market outlook for this strategy as a trader is that you're looking for a completely flat stock and virtually no movement at all, and I mean no movement.
You want a stock that is trading flat, very little intraday and daily movement. The market neutral strategy is designed for low volatility conditions where stocks are inactive, and you can collect a premium as a result. That’s the only strategy that I would use this particular short straddle on going forward.
Now, how to set up a short straddle is pretty easy. You're going to think about it like selling two options individually; you’re just going to put them together. You're simply going to sell a call option and a put option with the same strike price for the same expiration period.
In our example here, what we’re going to do is sell one at the money call at a strike price of 40, and we’re also going to sell another at the money put at a strike price of 40 and that creates the point here where the option payoff diagram pivots.
Now, to learn more about option payoff diagrams, just watch one of our other video tutorials. Now, you can shift your sales up or down, but most strategies are centered on the money.
You can shift these strategies to the right or the left, you can shift them up towards 50 or down towards 30, but, if you want the stock to trade virtually flat or no movement at all, you’re going to center it right around where the stock is trading right now. That's going to be your biggest area of profit potential.
What’s the risk? Well, the risk of this strategy is that the stock moves outside of your boundary or breakeven point and there is a maximum loss probability here or unlimited potential with this strategy because the stock can go up exponentially in price.
If that happens, then you could see big losses. Of course, you can mitigate this loss with some of the premia that you received and hedging strategy that I’m going to talk about here at the end of this video.
The profit potential for this strategy is pretty limited. The maximum gain you can get is just the income you receive from selling both options.
Remember that we’re going to take income to the right off the bat, and we want to keep as much of that income as possible, we can't get any more income, you can see it’s 100% capped at $400, you can’t get more than that on this particular strategy.
Since we’re selling options with the same strike price, using the money options, you stand to make good income should the stocks stay flat. As we talked about earlier, you don't want any volatility movement in this particular strategy.
Remember that volatility is very, very bad. You want no volatility. You want the stock to trade flat or even. Any increases in implied volatility could create a loss even if the stock doesn't move.
If generally, options are more volatile and your stock still doesn’t move, then even that one factor of implied volatility can create a small loss for your strategy.
Time decay is positive for this particular options strategy. Since we are selling options and taking in that premium right off the bat, the best thing that can happen is that these options can expire worthlessly.
Each day that the stock doesn't move or move slightly creates the opportunity for making money. Remember that time decay for this strategy means profits and usually, time decay for any option selling strategy means more profit and more income. Now, breakeven points are very easy to calculate.
It's very similar to how we calculated them with long straddles as well. But with short straddle, what you’re going to do for the upper-level breakeven point is you’re going to take the short call value, and you’re going to add the premium that you received, and that’s going to give you this particular point here on the graph which is where it breaks even on the upper level.
For the lower level, you’re going to take the short put strike, and you’re going to subtract the premium that you received as well and that creates this other lower level breakeven point. As long as the stock closes inside this range centered around 40, you’re going to make money at expiration.
Now, let’s look at an example here. Let’s say the stock is trading at a price of around $40, right here where my cursor is. You’re going to sell one 40 calls for $200, and then you’re going to sell a 40 put for $200 as well, taking in a total of $400 on the trade combined.
Now, your maximum loss is unlimited because the stock can continue to rise or continue to fall. We want it to stay very, very neutral to flat. The maximum profit you can make on this strategy is $400, and that is the credit that you receive for selling these options.
You can’t make any more than that. And notice on my chart here how the profit loss diagram is capped at $400. Some tips and tricks that I’ve learned over the years that I want to share with you guys: Many months of consistent profits with this strategy can be quickly erased without proper risk management.
I guess that could be used in any trading strategy that you have. But this, in particular, I’ve seen a lot of traders who have used this very consistently over a couple of months, they make a couple of hundred dollars, and they wipe it out during periods of high volatility.
You want to use these during periods of high to low volatility versus adding during periods of already low volatility. If you add during periods of low volatility, then you run the risk of increasing volatility that the stock has a breakout.
What you'd ideally like to do is capture the stock after it's already made a dramatic move and is starting to settle down. Now, you can easily hedge this position by purchasing another call or put and creating a credit spread on either end.
I’m going to show you what this means with my cursor. Let's say that the stock is starting to move outside of the 40 mark. You can easily purchase a call option right here at a strike price of 50, and it would cap your losses at the 50 strike price.
Same thing if the stock was starting to move down dramatically. You could easily purchase a put option with a strike price of 30, and that would cap your losses to the downside at 30.
This is something you can do later on down the road as you start to adjust and watch this position evolve. You don't have to do it right now or as soon as you enter this position, but you should have it at least in the back of your mind here as a way to hedge and protect the unlimited risk feature of this strategy.
As always, I hope you guys enjoyed this video and thanks for watching. Please use the social links right below here to share this video with your friends, family or colleagues on your favorite social network.