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In essence, the short strap straddle is the same strategy as a short straddle, but with an extra short call thrown into the mix.
That gives the trader a nice bundle of cash up front, but it also adds significant risk to the initiative. If the underlying should start trending strongly, particularly to the upside, the unhappy trader will start taking on water twice as fast as he would had a downside move ensued.
Limited Profits/Unlimited Risk
The short strap straddle is composed of (at least) three naked options, making it a theoretically unlimited loss proposition. At the same time, the maximum gain is limited to the initial credit taken.
Let’s have a look at a real-life trading scenario to better appreciate the appropriate use of the strategy.
Below is a chart of oil giant Royal Dutch Shell PLC (OTC: RYDAF) over an eight-month span:
Royal Dutch Shell has been trading in a range for a number of months (in red), and your studies lead you to believe that the meander will continue for some time to come. Crude oil has been steady, and there appear to be few catalysts on the horizon that might lead to a spike in either direction, as far as you can see.
At the same time, you believe that if a breakout does ensue, it will almost certainly be lower, as some OPEC members are making noise about flooding the market with cheap supply if certain unrelated diplomatic demands aren’t acceded to.
With that as your premise, you figure a short strap straddle has the best chance of producing profits. It’s a strategy that capitalizes on low volatility, but stands to gain more should the underlying drift lower, rather than higher.
The stock is trading at $41 when you open the trade (in green). You sell two at-the-money October 41 calls for $4 each and one October 41 put for another $4. Your credit on the trade is an even $12.
And then you wait…
The stock continues in its range for another two months and then, as you suspected, it starts to slide.
By the beginning of October, the move steepens, and you start to sweat. You check your break-even calculations to make sure you’re still safe. On the downside, your single, short put starts to cost you money once the initial premium on the trade is eaten up. That occurs at $29 ($41 – $12).
Whew! The stock doesn’t quite make it that far. It bottoms at $33 mid-month, then turns higher to close at $35 upon expiry (in blue).
The put is in the money $6, and just before the close, you buy it back for exactly that amount. Your profit on the venture, therefore, is $600 even ([$12 – $6] x 100), and you thank your lucky stars it turned out so well.
Dangerous Trade
Traders have to monitor the short strap straddle closely to ensure the stock doesn’t move significantly before expiry.
As noted above, the downside break-even occurs $12 below the strike price (at which point the original premium will have been nullified). But on the upside, it occurs at exactly half that distance. In our example, it’s $47 ($41 + [$12/2]).
Did you collect your $1,170?
How about your $1,150? Or your $1,280? You could have been collecting this cash month after month—just by making a few simple clicks. It’s all thanks to one of the world’s safest, most powerful trading strategies. One some very powerful people would prefer you never discover. But I’ve put it all together for you right here.