Short Straddles

The short straddle has a bad rap given it is a strategy with unlimited risk on both sides of the strategy. If you sell a short straddle on a stock, ETF or index and the underlying moves substantially higher or lower, you can see substantial losses. However, it is a strategy that is commonly misunderstood, and in this post we will explore how to utilize it in a portfolio. It should be noted that short straddles are not suitable for all options traders. It requires both a relatively large trading account and a high tolerance for risk, given the sizable drawdowns that can occur. However, the trade-off is that it is a strategy that has one of the shortest drawdown recovery time.

What is a Short Straddle?

The short straddle is an options income strategy that is used by traders to profit from a sideways market and contracting volatility environment. This strategy involves simultaneously selling a call option and a put option with the same strike price and expiration date for a premium. The goal of the short straddle is to take advantage of the time decay of the options, as well as any potential decrease in implied volatility in order to generate a profit. This strategy realizes maximum profit potential when the underlying security remains exactly at the strike price allowing the trader to keep the initial premium received. Alternatively, the short straddle can also be bought to close at a lower premium to generate a profit. However, if the security exceeds the higher or lower breakeven point of the straddle, there will be unlimited losses depending on how far it deviates from that breakeven point.

• Max reward = premium collected
• Max risk = unlimited
• Breakevens = strike price + total premium collected, strike price – premium collected

Another advantage of the short straddle strategy is its ability to generate income. By selling both a call and a put option, the trader is able to receive two premiums, which can be used to generate income for their portfolio. This is especially appealing for traders who are looking for ways to generate passive income from their investments.

Example:

Stock $XYZ currently trading at $100:

• Sell 1 month $100 Call @ $4
• Sell 1 month $100 Put @ $4
• Collect a total of $8
• Max reward = $8
• Max risk = Unlimited
• Breakevens @ $92 and $108

Options Greeks

The Greeks have an important role in this strategy:

• Short Volatility (Vega) – when selling an option, the trader is short volatility (declining volatility works in favor of this strategy). In the case of a straddle, it is short Vega from both the call and put options.
• Short Theta (Time Decay) – time decay works in favour of an option seller. Like Vega, straddles are exposed to time decay for both the call and put options. The options’ price will decline with time and the trader can buy to close the position at a lower price.
• Short Straddles are Delta neutral initially but will drift as the underlying moves higher or lower. Assuming the call option has a -50 Delta and the put option has a 50 Delta, both legs offset each other resulting in a net 0 Delta trade. However, as the underlying drifts further away from the strike price, the Delta exposure gained will offset the gains from the short Theta and Vega.

Short straddles work best during higher implied volatility environments, typically measured with high IV Rank (implied volatility) securities. High IV Rank options have a higher probability of implied volatility moving lower and lower the price of the option. Securities with higher IVs increase the breakeven buffer on the trade. Additionally, when selling straddles, traders should be aware of upcoming earnings that have the potential to move the underlying price significantly higher or lower.

Optimal Strategies and Trade Management

Generally, traders should look to sell straddles with 45 days to expiration. Forty-five (45) days provide a balance between Theta decay acceleration with lower Gamma risk. Consider these best practices for selling straddles:

• Strikes – Sell ATM call and put (-50, 50 Deltas)
• Take Profit – At 25% of max gain OR 21 days to expiration. Traders choosing to roll this strategy should roll it to another 45 DTE.
• Stop Loss – At 50% of max gain.

Short straddles provide an effective way to generate income due to selling both a call and a put. However, this creates an unlimited risk profile. Therefore, traders looking to sell short straddles should understand and understand the law of large numbers when deploying this strategy.

The Law of Large Numbers

The law of large numbers is a concept in statistics and probability that states that as the number of observations or trials increases, the average of the results will approach the expected value. In the context of an insurance company’s business, the law of large numbers is an important principle that helps to ensure the long-term stability and profitability of the company.

Insurance companies rely on the law of large numbers to manage risk and make informed decisions about pricing and underwriting. By pooling the risks of a large number of policyholders, an insurance company is able to reduce its overall exposure to any one particular risk. This allows the company to spread its risk over a large population, making it less likely that any single loss will have a significant impact on its overall financial performance.

The concept of the law of large numbers can also be applied to options trading with selling straddles. Just like insurance companies, options traders can spread their risk over a large number of trades, reducing the impact of any single loss. By diversifying their portfolio and making a large number of trades, options traders can reduce their overall exposure to any one particular risk and ensure the long-term stability of their portfolio.

By selling straddles, a trader is essentially betting that the price of the underlying asset will remain within a certain range and not experience significant changes in price. By selling many straddles, the trader can reduce the impact of any single loss and ensure the long-term stability of their portfolio. This simply requires a larger account to have the capital to sell multiple straddles at once, where each trade accounts for a small percentage of risk relative to the trading account.

Consider a trader who sells 10 straddles. If the price of the underlying asset moves significantly in either direction, the trader may experience a significant loss on one or more of their straddles. However, if the trader sells 100 straddles, the impact of any single loss is reduced, making it less likely that a single loss will have a significant impact on their overall profitability.

Summary
Short straddles are an options strategy that may not suit every investor. However, for investors who have a sizeable trading account, short straddles can generate a significant amount of income compared to other income generating strategies, while taking on a significant amount of risk with each straddle. The key to success with this strategy is a combination of spreading the risk of each trade over a large number of trades and following the best practices for entering and exiting the position. Lastly, it is important that when losses occur with a short straddle strategy, to recuperate those losses, one must continue to sell straddles and spread the risk over a large number of trades.

Tony Zhang is a specialist in the financial services industry with over a decade of experience spanning product development, research and market strategist roles across equities, foreign exchange and derivatives. As the current Head of Product Strategy for OptionsPlay, Tony leads the research and development of their OptionsPlay Ideas & Portfolio platform. He has leveraged his interest in financial technology and product development to provide innovative, reimagined solutions to clients and the users they seek to serve. Previously he spent 7 years at FOREX.com with a capital markets and research background as a market strategist specializing in equity and FX derivatives markets.

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