To profit from little or no price movement in the underlying stock.
A short straddle consists of one short call and one short put. Both options have the same underlying stock, the same strike price and the same expiration date. A short straddle is established for a net credit (or net receipt) and profits if the underlying stock trades in a narrow range between the break-even points. 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.
Example of short straddle
|Sell 1 XYZ 100 call at||3.30|
|Sell 1 XYZ 100 put at||3.20|
|Net credit =||6.50|
Profit potential is limited to the total premiums received less commissions. The maximum profit is earned if the short straddle is held to expiration, the stock price closes exactly at the strike price and both options expire worthless.
Potential loss is unlimited on the upside, because the stock price can rise indefinitely. On the downside, potential loss is substantial, because the stock price can fall to zero.
Breakeven stock price at expiration
There are two potential break-even points:
- Strike price plus total premium: In this example: 100.00 + 6.50 = 106.50
- Strike price minus total premium: In this example: 100.00 – 6.50 = 93.50
Profit/Loss diagram and table: short straddle
|Short 1 100 call at||3.30|
|Short 1 100 put at||3.20|
|Total credit =||6.50|
|Stock Price at Expiration||Short 100 Call Profit/(Loss) at Expiration||Short 100 Put Profit/(Loss) at Expiration||Short Straddle Profit / (Loss) at Expiration|
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.”
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.
Risk of early assignment
Stock options in the United States can be exercised on any business day, and the holder of a short stock option position has no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options.
Both the short call and the short put in a short straddle have early assignment risk. Early assignment of stock options is generally related to dividends.
Short calls that are assigned early are generally assigned on the day before the ex-dividend date. In-the-money calls whose time value is less than the dividend have a high likelihood of being assigned. Therefore, if the stock price is above the strike price of the short straddle, an assessment must be made if early assignment is likely. If assignment is deemed likely, and if a short stock position is not wanted, then appropriate action must be taken before assignment occurs (either buying the short call and keeping the short put open, or closing the entire straddle).
Short puts that are assigned early are generally assigned on the ex-dividend date. In-the-money puts, whose time value is less than the dividend, have a high likelihood of being assigned. Therefore, if the stock price is below the strike price of the short straddle, an assessment must be made if early assignment is likely. If assignment is deemed likely and if a long stock position is not wanted, then appropriate action must be taken before assignment occurs (either buying the short put and keeping the short call open, or closing the entire straddle).
If early assignment of a stock option does occur, then stock is purchased (short put) or sold (short call). If no offsetting stock position exists, then a stock position is created. If the stock position is not wanted, it can be closed in the marketplace by taking appropriate action (selling or buying). Note, however, that the date of the closing stock transaction will be one day later than the date of the opening stock transaction (from assignment). This one-day difference will result in additional fees, including interest charges and commissions. Assignment of a short option might also trigger a margin call if there is not sufficient account equity to support the stock position.
Potential position created at expiration
There are three possible outcomes at expiration. The stock price can be at the strike price of a short straddle, above it or below it.
If the stock price is at the strike price of a short straddle at expiration, then both the call and the put expire worthless and no stock position is created.
If the stock price is above the strike price at expiration, the put expires worthless, the short call is assigned, stock is sold at the strike price and a short stock position is created. If a short stock position is not wanted, the call must be closed (purchased) prior to expiration.
If the stock price is below the strike price at expiration, the call expires worthless, the short put is assigned, stock is purchased at the strike price and a long stock position is created. If a long stock position is not wanted, the put must be closed (purchased) prior to expiration.
Note: options are automatically exercised at expiration if they are one cent ($0.01) in the money. Therefore, if the stock price is “close” to the strike price as expiration approaches, assignment of one option in a short straddle is highly likely. If the holder of a short straddle wants to avoid having a stock position, the short straddle must be closed (purchased) prior to expiration.
Short straddles are often compared to short strangles, and traders frequently debate which the “better” strategy is.
Short straddles involve selling a call and put with the same strike price. For example, sell a 100 Call and sell a 100 Put. Short strangles, however, involve selling a call with a higher strike price and selling a put with a lower strike price. For example, sell a 105 Call and sell a 95 Put.
Neither strategy is “better” in an absolute sense. There are tradeoffs.
There is one advantage and three disadvantages of a short straddle. The advantage of a short straddle is that the premium received and maximum profit potential of one straddle (one call and one put) is greater than for one strangle. The first disadvantage is that the breakeven points are closer together for a straddle than for a comparable strangle. Second, there is a smaller chance that a straddle will make its maximum profit potential if it is held to expiration. Third, short straddles are less sensitive to time decay than short strangles. Thus, when there is little or no stock price movement, a short straddle will experience a lower percentage profit over a given time period than a comparable strangle.
The short strangle three advantages and one disadvantage. The first advantage is that the breakeven points for a short strangle are further apart than for a comparable straddle. Second, there is a greater chance of making 100% of the premium received if a short strangle is held to expiration. Third, strangles are more sensitive to time decay than short straddles. Thus, when there is little or no stock price movement, a short strangle will experience a greater percentage profit over a given time period than a comparable short straddle. The disadvantage is that the premium received and maximum profit potential for selling one strangle are lower than for one straddle.