Short Straddle

A short straddle is a combination of writing uncovered calls (bearish) and writing uncovered puts (bullish), both with the same strike price and expiration. Together, they produce a position that predicts a narrow trading range for the underlying stock.

Market Outlook

Market participants looking for a steady stock price during the life of the options, and an even or declining level of volatility.Because of the substantial risk, should the stock price move out of the expected trading range, the opinion about the stock’s near-term steadiness is likely to be fairly strongly held.

When to Use

An investor often employs a short straddle to earn income from selling premium. Short straddles are best employed when investors also expect the underlying to move very little over the life of the options.

Profit & Loss Chart

Benefit

This strategy has limited profit potential, but the potential loss is unlimited.  If an investor believes that the underlying will move very little over the course of the options life, they may capture profit by selling time premium. Though, investors should be aware that this position has the potential for unlimited losses.

Risk & Reward

Maximum Profit: Limited
Maximum Loss: Unlimited

The maximum gain is limited to the premiums received at the outset. The best that can happen is for the stock price, at expiration, to be exactly at the strike price.  In that case, both short options expire worthless, and the investor pockets the premium received for selling the options.

The maximum risk is unlimited. The worst that can happen is for the stock to rise to infinity, and the next-to-worst outcome is for the stock to fall to zero. In the first case, the loss is infinitely large; and in the second, the loss is the strike price. In either event, the loss is reduced by the amount of premium income received for selling the options.If the stock price is higher than the call strike, the investor will be assigned and therefore obligated to sell stock at the strike price and buy it in the market. If the stock price is lower than the put strike, the investor will be assigned and therefore be obligated to buy stock at the strike price, regardless of the lower market value. That means either liquidating it in the market for an immediate loss, or keeping a stock that cost more than its current market value.

Break Even Point

Upside Breakeven = Strike Premiums Received

Downside Breakeven = Strike – Premiums Received

This strategy breaks even if, at expiration, the stock price is either above or below the strike price by the total amount of premium income received.  At either of those levels, one option’s intrinsic value will equal the premium received for selling both options, while the other option will be expiring worthless.

Volatility Changes

Increase In Volatility: Negative Effect
Decrease In Volatility: Positive Effect

This strategy’s chances of success would be better if implied volatility were to fall. If the stock price holds steady and implied volatility falls quickly, the investor might conceivably be able to close out the position for a profit well before expiration.

Conversely, if implied volatility rises unexpectedly, the effect on this strategy is very negative. Assignment seems likelier (at least in the market’s opinion), and consequently the cost of closing out the straddle escalates as well. It could force the investor to close out at a loss, if only to prevent further losses.

Time Decay (Theta)

Positive Effect

Every day that passes without a move in the underlying stock price brings both options one day closer to expiring worthless, which would obvioulsy be the investor’s best-case scenario. This position benefits from the passage of time, all other things being equal.