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A short strip straddle is the mirror image strategy of a strip straddle, comprised of a single at-the-money short call and two short at-the-money puts.
The trade is essentially a bet on low volatility, with a slightly bullish bent. That is, if the stock should begin trending and the trader faces a potential loss, it’s believed more likely that the move will be higher.
Unlimited Losses/Defined Gains
Like a straight short straddle, the short strip straddle is a dangerous strategy, insofar as any movement in the underlying immediately puts the options into the money. Should the move be lower, the risk is twice as great, as the two short puts piggyback on one another to erase the initial premium garnered.
On the flip side, the maximum gain on the trade occurs when the underlying expires precisely on the strike price, at which point the trader pockets the full credit taken.
Let’s look now at a half year’s worth of chart for AT&T (NYSE: T) to better understand the trade’s workings.
In late October, your research tells you that recent volatility in the telecoms is coming to an end. You want to capitalize on that lack of volatility, but you’re not sure if your analysis is 100% correct, or if any surprise that might ensue would be to the upside or down. You have suspicions that the break, if it came, would be higher, as both the fundamental and technical picture for the sector is solid.
With that in mind – and in an effort to squeeze as much premium as possible from the initiative – you decide on a short strip straddle, a trade that profits from a stagnant future over the near term, but that’s “hedged” toward a possible bullish breakout.
With the stock trading at exactly $34 you decide to act, selling the February 34 call for $2.50 and two February 34 puts for $2.50 each. Your total credit for the trade is $7.50.
Meander, Slide and Pop!
For the next three months, the stock trades in a tight range, between $33 and $35, with just a brief duck toward $32 that gets your heart pounding.
And then, with a month still remaining until expiry, AT&T jumps above the existing range and climbs steadily to close at $36.50 on expiry.
Your two short puts, of course, close out of the money, but the short call is in the money $2.50 just minutes before expiry, and that’s where you close it. You buy it back and net out $500 for the effort ([$2.50 + $2.50 + $2.50 – $2.50] x 100).
Had the trade moved lower by the same amount, the loss on the short puts would have been $5.00, cutting your profit in half.
Break-even for the trade occurs when the move in the underlying eats up the initial premium taken. In the above example, the upside break-even occurs at $41.50 (strike price [$34] + premium taken [$7.50]). On the downside, the break-even comes earlier, at $30.25 (strike price [$34] – premium taken [$7.50]/2).
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