The short straddle strategy is normally considered to be a risky option trade, due to it's potential unlimited risk should the price action of the underlying move dramatically in either direction. However, as we shall see, if you use the this strategy in combination with a plan to trade the underlying as well, it can not only be minimal risk but quite profitable as well.
In direct contrast to the long straddle where you buy an equal number of both call and put options at the same at-the-money (ATM) strike price and with the same expiration date ... a short straddle involves selling the same number of ATM calls and puts with same expiration date and strike price.
The benefit is that you receive a double credit to your account for the sold options, which can be offset against any adverse movements. Since your objective here is for the price of the underlying to remain as neutral as possible until expiration, you would want your time to expiration to be as short as possible. This is where weekly and binary options, some of which have only hours to expiration, may prove a distinct advantage.
If you know anything about options, you'll immediately recognize the risk. Whichever way the underlying moves once your position is entered, will put either the call or put options "in-the-money". If your option strikes prices are say $30 and the price suddenly jumps to $45 your call options will be $15 in the money. This means you have to purchase the underlying at $45 in order to deliver it to the market which may "call" it from you at only $30, thus making a $15 per share loss in the process. Add to that the leverage inherent in options contracts and the potential for loss is positively frightening! The further north the price of the underlying goes, the more you lose. It is potentially unlimited. In this scenario, you will only have the credit you received from executing the short straddle, to offset the loss.
One option strategy is to modify the straddle trade so that you protect your risk with buying an equal number of call and put options which are out-of-the-money (OTM). This combination of short and long positions is called a long iron butterfly spread. It is in effect, a double credit spread, facing opposite directions with one set of strike prices laid upon another. You sell the body and buy the wings.
Trading With the Underlying - Example
Let's use a vanilla forex options trading example. The current price of the GBPUSD pair is 1.40. You purchase an ATM short straddle with a very short time to expiration and receive a credit. Immediately, you set up a pending order to either buy the underlying spot market for the GBPUSD at a price above, or sell it at a price below, the straddle. You will need your pending order to cover the same volume of the currency as covered by the short options contracts. In deciding where to execute your potential spot trades, you take into account the credit from your straddle plus brokerage commissions.
Should the price of the underlying tank, you will automatically enter a spot forex trade with leverage of 1:1 to the downside. The further it goes south, the more your spot position will make and it will cover losses from the short put option position. Same deal for the upside. If the market remains within the option strike prices and the pending order prices for the spot market until expiration time, you keep the initial credit.
Play around with it! Get a feel for how it works using risk analysis graphs. You'll know what I mean.
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