Short Straddle

When to Use a Short Straddle

The short straddle is a suitable strategy when your outlook on a security is neutral: meaning that you don’t believe the price will either go up much or go down much. It should only be used when you are very confident that the price of the security won't move significantly in either direction, because the potential loss if that does happen can be very substantial.

You will require a high trading level to create this spread, so it isn't likely to be possible for you if you are relatively new to options trading.

How to Use a Short Straddle

Establishing the short straddle spread is very simple. You need to use the sell to open order to write at the money calls on the relevant underlying security and also write the same number of puts on the same security. Both sets of options should have the same expiration date, which can be as near term or as long term as you like.

Writing near term options will mean there is less time for the security to move in price, and as such gives you a better chance of profiting. Writing longer term ones will mean there's more time for the security to move in price, so the risks are greater. However, longer term ones are generally more expensive so you will receive more money for writing them.

As both transactions involve writing options, there's no cost associated and you actually receive an upfront credit. The short straddle is therefore a type of credit spread. This means that your broker will require margin from you, because the spread could end up costing you money. Below is an example of how and when you might use a short straddle.

• Company X stock is trading at $50, and your expectation is that it will stay trading at close to that $50 for a period of time.
• At the money calls (strike $50) are trading at $2. You write 1 contract of these (containing 100 options), for a credit of $200. This is Leg A.
• At the money puts (strike $50) are trading at $2. You also write 1 contract of these, for a further credit of $200. This is Leg B.
• These two transactions combined have created a short straddle, with a total upfront credit of $400.

We should point out that this example uses hypothetical options prices rather than exact market data, and we haven't included commission costs for the sake of simplicity.

Potential Profits & Losses

The maximum profit you can make is the upfront credit ($400 in the above example). To make the maximum profit you need both legs of the spread to expire worthless, which will happen if the price of the underlying security remains exactly at $50. In practice this is very unlikely, but the short straddle still returns a profit providing the price of the stock doesn't move far enough in either direction to create a liability on either of the legs that is higher than the net credit received.

For instance, if the security went up to $53, then you would have a liability of $3 per call written in Leg A (a total liability of $300). As the net credit is $400, you would still make a profit.

However, if the security went up to $58, then you would have a liability of $8 per call written in Leg A (a total liability of $800). Although the $400 net credit would offset some of that liability, you would still lose a total of $400.

Your potential losses are unlimited: the more the security goes up in price, or goes down in price, the more you will lose. The potential profits and losses of the short straddle can be calculated as follows.

• Maximum profit is made when “Price of Underlying Stock = Strike of Options”
• Maximum profit is the credit received i.e. “(Price of Options in Leg A x Number of Options Written) + (Price of Options in Leg B x Number of Options Written)”
• The short straddle has an upper break-even point and a lower break-even point.
• Upper Break-Even Point = “Strike of Leg A + (Price of Options in Leg A + Price of Options in Leg B)”
• Lower Break-Even Point = “Strike of Leg B – (Price of Options in Leg A + Price of Options in Leg B)
• The short straddle will return a profit any time “Price of Underlying Security < Upper Break-Even Point and > Lower Break-Even Point”
• The short straddle will result in a loss if “Price of Underlying Security > Upper Break-Even Point or < Lower Break-Even Point”

You can close the position at any time prior to expiraion by buying back all the options. You may choose to do this if time decay has eroded the price of the options sufficiently to return an acceptable profit, or if you want to cut your losses if the price of the underlying security has moved outside the break-even points.

Short Strip Straddle & Short Strap Straddle

There are two variations of the short straddle that are also worth considering: the short strip straddle and the short strap straddle.

The short strip straddle involves writing more puts than calls options. You would use this if your outlook was neutral but you thought there was a chance the underlying security could increase in price. By writing additional puts, the higher break-even point becomes higher and you also increase the net credit received. However, if the price of the security does fall below the lower break-even point you will lose more money.

The short strap straddle basically works in reverse, and you would use this if you thought there was a chance the price of the underlying security could fall. You would write additional calls, meaning the lower break-even points would be lower. Again, you would increase the net credit received, but you would be exposed to greater losses if the price of the security rose above the higher break-even point.

Summary

This is a straightforward strategy, requiring two simple enough transactions. It's essentially a combination of short calls and the short puts, and it profits from the effects of time decay if the price of the security remains relatively stable.

It's one of the easiest ways to profit from a neutral outlook, but the losses can be substantial so it should only really be used if you are particularly confident that the price of security will not move dramatically in either direction.