Is your stock in a rut? It’s not moving up or down? In this article, we’re going focus on a way to capitalize on an apathetic stock by initiating a short straddle.
Who should tune in? While the long-straddle strategist anticipates a significant move in the underlying stock price, the short-straddle strategist expects just the opposite. The investor is expecting minimal movement from the stock in the short term, and must be rather accurate in his predictions in order to succeed.
With this in mind, the short spread strategy should be tackled only by advanced traders with time to devote to closely watching the charts.
How does it work? Once the investor has singled out a stock, he would then simultaneously sell an equal number of puts and calls with the same strike and same expiration date.
Usually, both options will be at or near the money, and will center on the strike that the investor thinks the stock price will settle at options expiration. The options are usually of the near-term variety, as time decay is the option seller’s enemy, since it causes the value of the options to decrease.
What’s in it for me? The trader’s objective is for the underlying stock to remain at the strike price, so both the call and put expire worthless. If the investor’s predictions ring true, he can then pocket the initial premium received from selling the options.
There are two breakeven points for the short-straddle position: the strike price minus the net credit received and the strike price plus the net credit received.
What do I have to lose? Aye, there’s the rub… If the underlying stock declines below the strike price by expiration, the investor’s losses are limited to the strike price minus the net credit received. On the flip side, if the underlying equity rallies past the strike price by expiration, the short-straddle strategist’s losses could be theoretically unlimited.
Let’s look at an example.
Meet Reed. He’s a seasoned options player with his eyes on stock ABC, which has been range-bound for quite some time. Reed thinks the shares of ABC will remain near the $50 level during the next month or so, and decides to take advantage of the stock’s low volatility by initiating a short straddle.
First, Reed sells an ABC June 50 call for $3, or $300 (x 100 shares). Next, he sells an ABC June 50 put for $1, or $100. Reed’s net credit received from the sale of the two options is $400 ($300 + $100), which is also his maximum potential profit (minus any brokerage fees), should the shares of ABC remain at the $50 level by options expiration on Friday, June 19.
In order for his position to break even, the security must be trading now lower than $46 (strike – net credit received) and no higher than $54 (strike + net credit received) at expiration.
However, let’s say the shares of ABC skyrocketed to the $100 level on the heels of positive comments from the company’s CEO. Since Reed didn’t already own the shares of ABC prior to initiating the short straddle, he’s now obligated to buy 100 shares for the market price of $100 each, or $10,000 total, and sell them to the call buyer for the strike price of $50, or $5,000.
Subtracting the $100 he pocketed from the sale of the sold put, and adding the $300 he forfeited from the call premium, he’s incurred a loss of $5,200.
In conclusion…
It’s important to remember that the short straddle is for advanced investors, as it requires an extreme accuracy in predicting a stock’s movement (or lack thereof). Plus, selling options comes with the exposure to unlimited risk, while the reward for the short straddle is limited to the net credit received – and you get to pocket that only if you’re on-the-nose right at expiration.
In addition, because of the elevated risk of this strategy, the margin requirements can be quite high, so don’t forget to factor in any brokerage fees before embarking on your short-straddle journey.