Short straddles consist of selling a short call and a short put at the same strike price for the same expiration date. The strategy capitalizes on minimal stock movement, time decay, and decreasing volatility.
Short straddles are market neutral and have no directional bias. Short straddles require minimal movement from the underlying stock to be profitable. Credit is received when the position is opened. Beyond the premium collected, the risk is unlimited in both directions.
A short straddle is consists of a short call option and a short put option with the same strike price and expiration. Short straddles are typically sold at-the-money of the underlying asset. However, a short straddle can be opened above or below the stock price to create a bullish or bearish bias.
For example, if a stock is trading at $95, a short straddle centered at $100 would be a bullish position because the underlying asset's price must increase before expiration for the position to realize maximum profit.
The combined credit of the short call and short put define the maximum profit for the trade. The maximum risk is undefined beyond the credit received.
The short straddle payoff diagram resembles an upside-down “V” shape. The maximum profit on the trade is limited to the initial credit received. The maximum risk is undefined beyond the credit received. The break-even point for the trade is the combined credit of the two options contracts above and below the strike price.
For example, if a stock is trading at $100, a call and put option could be sold with a $100 strike price to create a short straddle. If the sale of the short straddle results in a $10.00 credit, the break-even prices would be $90 and $110.
The short straddle could be exited anytime before expiration by purchasing the short options. If the cost of buying the contracts is less than the initial credit received, the position will result in a profit.
Implied volatility will have an impact on the price of the options. As implied volatility decreases, the options contracts’ price will decrease as well, which works in favor of an options seller.
To enter a short straddle, sell-to-open (STO) a short call and a short put simultaneously at the same strike price and expiration date. For example, if a stock is trading at $100, a call option and put option could be sold at $100.
Higher volatility will equate to higher option prices. The longer the expiration date is from trade entry, the more the options will cost, and the more premium will be collected when sold.
A short straddle looks to capitalize on time decay, minimal price movement in a stock, a drop in volatility, or a combination of all three. At expiration, one of the short options will be in-the-money and at risk of assignment, so the position must be closed if assignment is to be avoided.
Any time before expiration, the position can be closed with a buy-to-close (BTC) order. If the options are purchased for less money than they were sold, the position will result in a profit.
Time decay, or theta, works in the advantage of the short straddle strategy. Every day the time value of an options contract decreases. Ideally, the underlying stock experiences minimal movement, and theta will exponentially lose value as the options approach expiration. The decline in value may allow the investor to purchase the options contracts for less money than initially sold.
Short straddles benefit from a decrease in the value of implied volatility—lower implied volatility results in lower options premium prices. Ideally, when a short straddle is initiated, implied volatility is higher than at exit or expiration. Future volatility, or vega, is uncertain and unpredictable. Still, it is good to know how volatility will affect the pricing of the straddle options.
Short straddles can be adjusted to extend the time horizon of the trade or by rolling one of the spreads up or down as the price of the underlying stock moves. If one side of the straddle is deep-in-the-money as the position approaches expiration, an investor has two choices to maximize the probability of success.
The entire position can be closed and reopened for a later expiration date. Adjusting a short straddle typically brings in more credit, which increases the maximum profit potential, decreases the maximum risk, and widens the break-even point. Contract size and expiration dates must remain the same to maintain the risk profile.
If one side of the straddle is challenged, the opposing short option could be rolled toward the stock price to receive additional credit. The additional credit widens the break-even point on the challenged side of the position and reduces overall risk, but the max loss remains undefined in either direction.
However, because short straddles are centered at the same strike price, adjusting one of the short options creates an “inverted” position, meaning the short call is below the short put. When inverted, the distance between the call and put options will be the least amount the position can be repurchased. If the credit received from the initial entry plus the credit received from the inversion is wider than the width of the inversion, the position may result in a profit.
For example, a short straddle centered at $100 received $10.00 of credit at trade entry. If the underlying stock price increases, the short put could be rolled up to $105. This creates a $5 inversion.
Assuming the adjustment brings in an additional $1.00 of credit, the maximum profit potential becomes $600 if the stock closes between $100 and $105 at expiration, because the spread could be purchased for no less than $5.00.
The short options of a straddle can be rolled out to extend the trade's duration. Time decay benefits short strategies. If the position is not profitable as expiration approaches, the original straddle may be closed and reopened with a future expiration date. This will likely result in a credit and widen the profit zone.
For example, if the original short straddle is centered at $100 with a June expiration date, and received $10.00 of premium, the investor could buy-to-close (BTC) the call and put option, and sell-to-open (STO) a new position in July. If this results in a $2.00 credit, the new break-even points will be $88 and $112.
Hedging a short straddle defines the risk of the trade if the underlying stock price has moved beyond the profit zone. To hedge against further risk, an investor may choose to purchase a long option to create a credit spread on one or both sides of the position.
For example, if the short straddle is centered at $100, and the stock is challenging the position, a long call with a $110 strike price could be purchased to limit risk if the stock continued higher. If the short straddle collected a premium of $10.00 at trade entry, and the the long call cost $5.00, the break-even points would tighten to $95 and $105. The maximum profit potential is reduced to $500, but the maximum loss above the long call is the spread width of the call options, minus the overall credit received ($500). However, the max risk is still undefined below the short put if the stock reversed lower.
Conversely, if the stock price declined, a long put with a $90 strike price could be purchased to define risk if the stock continued lower. If the long put cost $5.00, the max profit potential is reduced and the max loss becomes the spread width of the put options, minus the overall credit received ($500). The max risk is still undefined above the short strikes if the stock reversed higher.
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