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neutral strategies

Short Straddles

Analyzing the risk profile of a short straddle

Risk Profile & Summary

Standard Setup

The standard setup for a straddle is to simultaneously
a
and a
at the same
nearest to the current share price. In this case, we sold the +50Δ put and the -50Δ call, resulting in a completely delta-neutral (0Δ) position.
Risk Profile: Neutral Short Straddle

How It Works

Short straddles, much like
profit off of decaying option value. In other words, they profit when option prices decline. They lose when option prices rise. Options' values decay the most when they are
declines
and
draws closer (
The most we can possibly make on a straddle is the amount we collect for selling it.
Straddles have the most profit potential when the share price is pinned directly on the strike as shown in the image above. If this happens, neither the call nor the put will have
giving both options the opportunity to become worthless at
The odds of the share price landing directly on the strike at expiration, however, is extremely low - almost zero. Knowing this, we can assume that the straddle will most likely have at least some intrinsic value at virtually all times. Since intrinsic value cannot decay, we should not expect to make 100% of maximum profit on this strategy. Instead, we should look to cash out early. Tastytrade research suggests that 25% of maximum profit is optimal.
The odds of
also known as
for a straddle is usually around 50%. Straddles can be skewed to one direction, however, which may affect the amount of credit received, the POP, and the
risk. Selling a straddle at a strike higher than the current share price, for example, will make the straddle lean
It may bring in a larger credit but will reduce the profitable range to the downside. On the flip-side, selling a straddle at a strike lower than the current share price will cause the straddle to lean
. Likewise, it may result in a larger credit but reduce the profitable range to the upside.

Why We Do This

Short straddles using an
strike offer traders a way to collect the largest amount of extrinsic value compared to any other strategy. They are often used when a trader feels like taking a bit more risk for a higher profit potential. If we believe risk perception is at a high (as measured by
and going to decline, a straddle can be sold to make money as premium decays. At-the-money strikes tend to have the highest rate of decay so, if premium decays as hoped, and the share price lands near the center of your straddle, it can result in large profits. Premium decays naturally as time passes and is accelerated by declining IV. Please revisit Pricing Options: Intrinsic & Extrinsic Value and Pricing Options: Time if you need a refresher on extrinsic value and premium decay.
Straddles might also be the result of defensive maneuvers in a trade that isn't working as planned. If an option gets
the trader might decide to sell the opposing contract at the same strike as a way to
against further damage. For example, if the trader has a short put and the share price drops below the strike, the trader might decide to sell a call at the same strike to soften the blow in case the share price continues to fall. We will cover defense in greater detail in an article down the road.

The Risks

Much like short strangles, the risks of a short straddle boil down to volatility. Straddles can lose money if:
  1. Implied volatility increases too much after trade entry
  2. The share price is overly volatile and moves too far away from the strike
If implied volatility were to expand after a short straddle has been sold, option prices will rise due to increased extrinsic value. This would negatively impact your P/L, even if the share price remains in the green profit zone. As long as the share price stays within the green zone, however, the extrinsic value will decay by expiration and result in profit.
If the share price moves too far in either direction it can negatively affect our P/L because short straddles carry risk on both sides of their profit zone. Regardless of direction, if the share price is moving away from our strike, the position would begin to take on intrinsic value. If the intrinsic value exceeds the total credit collected at trade entry, the position will not be capable of profit. In this case, the only way to profit without taking defensive action would be if the share price reverted back toward the strike.
Lastly,
risk is a factor in any strategy including neutral strategies like the short straddle. The straddle may start off neutral, but will become directional as the share price changes. Due to the opposing call and put, the strategy moves
to the market. As the share price rises, the
causes the straddle to take on negative delta, making it
As the share price falls, the
causes the straddle to take on positive delta, making it
Keep in mind that short straddles carry
There is no predetermined limit to the amount of losses that can be incurred. Therefore, it is extremely important to only place straddles in products small enough that large swings outside the profit zone won't blow up your account.

Summary

Assumption Neutral/Adaptable
At trade entry, short straddles are usually thought of as neutral strategies which means they can be profitable whether the share price moves higher, lower, or stays the same as long (as it falls within a specific range). They are, however, adaptable strategies and can be skewed in any direction to fit the traders assumption. Their directional risk can also change depending on how the share price moves.
Cost Basis Credit
The cost basis for a short straddle is equal to the total credit received.
POP Low to Moderate to High
A short straddle typically has about a 50% probability of profit. Depending on strike selection, however, the POP has potential to vary.
Capital Requirement Moderate
In a
short straddles generally require less capital than long shares. The more expensive or volatile the
is, the higher the capital requirement will be.
Break Even (before commission and fees) Short strangles have two break-evens. The lower b/e is calculated by subtracting the total credit received from the strike. The upper b/e is calculated by adding the credit received to the strike.

Lower B/E = Strike - Credit

Upper B/E = Strike + Credit
Maximum Profit Credit Received
The most you can make on a short straddle is the amount you sell it for.

Max Profit = Credit × 100
Maximum Loss Undefined
Short straddles have undefined risk meaning there is no limit to how much you could potentially lose. Be extra cautious about your position size when dealing with undefined risk.
Capital Allocation (per position) 3-5% Max
Depending on account size, 3-5% of
is the maximum amount of
I would allocate to a short straddle position.
Profit Target 25%
The goal is to cash out early with around 25% of the maximum profit.
Delta (P/L rate of change) Dynamic
Short straddles carry dynamic delta which means their delta will change as the share price changes. As the share price moves higher, the straddle's delta will decrease and eventually become negative (bearish). As the share price moves lower, the straddle's delta will increase and eventually become positive (bullish).
Theta (Time decay) Positive
Short straddles carry positive theta which means they profit off the passage of time.
Vega (Implied volatility sensitivity) Negative
Short straddles carry negative vega. This means they benefit from decreases in
and are disadvantaged by increases.
Gamma (P/L Momentum) Negative
Short straddles carry negative gamma which means their delta decreases (or becomes more negative) as the share price rises. Inversely, it rises (becomes more positive) as the share price falls. In practical terms, this means that the position will slow down as it profits and accelerate as it loses.

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