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A short straddle is composed of a sale of one at-the-money call and one at-the-money put. It’s a neutral (non-directional), premium-generating strategy that’s essentially betting nothing will happen before the two options expire.
The trade is therefore termed “bearish on volatility” and is often employed in situations when a sideways drift is expected, such as a cooling off period after a steep run-up in a stock – or in the period directly following big news or an earnings report, after which stocks tend to go to sleep for an extended period.
Limited Profit/Unlimited Loss
The short straddle is also referred to as a “naked straddle” or a “naked straddle sell,” because it’s an uncovered trade and therefore open to theoretically unlimited losses. The gains, on the other hand, are limited to the initial premiums earned.
Let’s have a look at a case study to better appreciate the whats and wherefores of the short straddle strategy.
This is a chart of Hyatt Hotels (NYSE: H) for a six-month period:
Trade in Hyatt shares has been dull for months, and you believe there’s little chance that a pick-up lies ahead, what with the economic malaise in Europe and little cheer on the domestic economic front. No one is traveling, and the hotel business, despite a raft of inventive new promotions, is barely treading water.
You know enough not to tie up your capital in a long Hyatt trade at the moment, but is there another way to profit from it?
Your broker suggests you write a straddle, collect some premium and let time do its work for you.
You’re sold, and on a cold day in early February you jump into action (red circle).
A Fairly Defined Trading Range
The shares are trading for exactly $59 when you sell the June 59 call and the June 59 put, the former for $3 and the latter for $2.85. Your credit – and maximum possible gain for the trade – is therefore $585 ([$3 + $2.85] x 100). Your maximum loss is unlimited, and begins accruing the moment the underlying starts trending away from the strike price.
Fortunately for you, Hyatt decides to move in a fairly tight band, between roughly $57 and $60, for the next three months. In June it breaks lower and settles at expiration at exactly $57.50 (blue circle).
With the call safely out of the money, only the put remains alive to harm you. So just before the option expires, you buy it back for exactly $1.50 to close the trade.
How’d you do? You’re up $5.85 from the initial premium and in the hole $1.50 from the last minute put purchase, leaving you a net gain of $435.
Note: Your two break-even points on the trade are calculated by adding and subtracting the premium earned at the outset to the strike selected. In the above example, that amounts to $64.85 ($59 + $5.85) and $53.15 ($59 – $5.85), or a roughly 10% move either way from the time you initiated the trade.
Given what the stock had been doing until that time, and what you expected going forward, it appeared a pretty good bet that Hyatt would remain within those bounds.
A 95% Success Rate
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