A short straddle is a two-legged spread that offers an initial upfront credit, but carries the risk of potentially heavy (in fact, technically unlimited) losses. The strategy is intended to profit from either stagnant price action in the underlying stock, a sharp decline in implied volatility -- or both. So, while a straddle buyer is looking for a major price swing in the underlying stock, a straddle seller is expecting the shares to remain almost completely flat through expiration.
To initiate a short straddle, you will sell (to open) one put option, and simultaneously sell (to open) one call option. Both options will be based on the same underlying stock, and will share the same strike price and expiration date. Most often, the strike price of the options will closely correspond to the underlying stock's current price.
For example, let's say XYZ is pinned near the $50 strike, and you expect the shares to remain relatively lifeless over the next couple of weeks until expiration. To build a short straddle, you would sell one front-month 50-strike call at 0.86, and simultaneously sell one front-month 50-strike put at 1.05. Your total upfront credit for selling both options is 1.91, or $191 [(bid price of 0.86 x 100 shares) + (bid price of 1.05 x 100 shares)].
Be sure you're satisfied with your initial credit on the trade, since this amount doubles as your maximum potential profit. In the best-case scenario, XYZ will finish squarely at $50 upon front-month expiration, allowing both of your options to expire worthless. You'll need to take no further action to exit the trade, and you can pocket the total credit of $191 as your reward.
While the short straddle does require an accurate technical forecast, there's a little wiggle room on your path to profit. The two breakeven levels are calculated by adding your net credit to the call strike, and subtracting your net credit from the put strike. In this example, you can eke out a profit as long as the shares end the expiration cycle between $51.91 (50 + 1.91) and $48.09 (50 - 1.91).
However, if one of your options finishes in the money, you'll need to buy back the option in order to avoid assignment. This additional transaction will result in more brokerage fees, thereby eroding your (already limited) profit.
There's plenty of risk involved with a short straddle, which is why these premium-selling strategies are reserved for experienced option traders with margin accounts. By selling both a call option and a put option, you've essentially taken on the same risk as a shareholder on a downside move, while your potential losses on a rally are comparable to those of a short seller (e.g., theoretically unlimited).
If XYZ should drop to $40 by expiration, for example, your call option would expire worthless. Conversely, your put option would be worth $10 at expiration, and it would cost you $1,000 to buy it back -- resulting in a net loss of $809, after subtracting the net credit of $191. Likewise, a rally up to $60 would result in an equivalent loss on your call option.
Alternately, an in-the-money option could be assigned to you by the buyer. This would require you to either buy or sell 100 XYZ shares per contract at a loss.
In the worst-case scenario, your maximum loss on the put is equal to the strike price less net credit, or $48.09. Multiply that amount by the 100 shares controlled by your put option, and it will cost $4,809 to buy back the contract on a move down to zero by XYZ.
And, as noted earlier, the potential losses on the call are theoretically unlimited, as there's no concrete ceiling to keep a lid on the stock's price. As you can see, the short straddle play carries a rather high risk/reward ratio.
When entering a short straddle, high volatility works in your favor. That's because your maximum profit is determined by the price at which you sell the options, and high volatility translates into higher option premiums. As such, you should target scenarios where implied volatility is high relative to comparable historical volatility readings.
However, once you've opened the short straddle, you'd prefer to see implied volatility decline. Lower volatility will decrease the value of the sold options, which means it will cost less money to buy (to close) the contracts.
Generally speaking, it behooves a short straddle player to execute the trade within a short time frame. This makes your job as a technical forecaster easier, since the underlying stock has less time to move against you.
While it's certainly not a low-risk trade, some speculators like to implement short straddles ahead of events like earnings, when implied volatility is often pumped up. These traders are expecting that the post-event plunge in volatility (a.k.a. the "volatility crush") will be sufficiently great to offset any corresponding move in the share price, allowing them to quickly exit the trade at a profit.