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 capitalize on decreasing volatility and minimal movement from the underlying stock to be profitable. Credit is received when a short straddle position is opened. Beyond the premium collected, the risk is unlimited in both directions. An investor would initiate a short straddle when the outlook for the stock price is relatively flat or neutral before expiration.
A short straddle is made up 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, they can be set up above or below the stock price to create a bullish or bearish bias.
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 or below the strike price.
For example, if a stock is trading at $100, a call and put option could be sold with a strike price of $100 to create a short straddle. If the sale of the short straddle results in a $10.00 credit, the break-even prices would be $110 and $90. 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 contracts should be repurchased if assignment is to be avoided.
Any time before expiration, the position can be exited by buying-to-close (BTC) the short contracts. 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 adjusted by rolling one leg of the option up or down as the price of the underlying stock moves. If one side of the short straddle is challenged as the contracts approach 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. If this results in a credit, the break-even points will be extended by the amount of premium received.
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 credit of $5.00, the new break-even points will be $115 and $85. If one side of the straddle is challenged, the opposing side could be rolled in the stock price’s direction to receive additional credit.
For example, if the short straddle is centered at $100 and stock is trading at $90, the $100 short call option could be closed and a new call option sold at a lower price. This is referred to as being “inverted.” The spread between the call and the put option will be the minimum amount for the trade to be repurchased. In this example, if the call option was reopened at $95, $5.00 would be the minimum amount the two options would be able to be purchased. To remain profitable, the amount of credit received would need to exceed the width of the spread.
The short options of a straddle can be rolled out into the future, and/or the strike prices can be rolled up or down to maximize the potential profit on the trade. The passing of time works in favor of an options seller. But, if time is running out before expiration and the position is not profitable, the original straddle may be purchased and sold for a future expiration date. This will likely result in a credit and extend the trade’s time duration and extend the profit zone.
Strike prices can also be rolled up or down if the stock price has moved beyond the break-even point. If the price has moved up, the original put option can be repurchased and resold at a higher price. This will collect more premium. This is known as going “inverted.” The distance between the call and put options will now be the minimum price at which the options can be purchased.
Hedging short straddles can define 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 short straddle.
For example, if the short straddle is centered at $100, and the stock is trading at $90, a long put could be purchased to cap the downside loss. At this point, the maximum loss possible is the width of the spread minus the credit received. If the $95 put were purchased, for example, the spread would be $5.00 wide. Buying the put will cost money, but it will limit the potential risk if the stock continued to fall.