What it means
A call option gives the buyer the right to buy a stock at a fixed price, and a put option gives the buyer the right to sell it at that price. In a short straddle you sell both, taking the opposite side of someone who expects a big move.
You are betting that the stock will be calm. The attraction is the amount of cash collected.
Because you sell two options, the premium income is larger than from a single option. If the stock finishes exactly at the strike, both options expire worthless and you keep every dollar.
The danger is on both sides. If the stock rises, the call you sold loses money without limit, since there is no ceiling on how high a share price can go.
If it falls, the put you sold loses money until the stock reaches zero. Because of this, brokers demand substantial margin, which is the collateral held against the risk, and usually restrict the strategy to experienced clients.
Traders often use it ahead of events where they think the market is expecting too much movement, and they watch it closely. Many close the position early to lock in part of the profit.
A common variant is the short strangle, which sells a call and a put at different strike prices, giving a wider zone of profit but a smaller premium. Another is to add long options further out to cap the loss, creating an iron butterfly.
Each variant trades some income for some protection.
In practice
Real-world examples.
Example
A professional options trader sells a straddle on a consumer goods company two days after its earnings release. The big news is out, and she expects the share price to be quiet until the next quarter. She collects $9.00 per share in premium and plans to close the trade when half of it has been earned.
Example
A trader at a small proprietary firm sells a straddle on an index before a central bank meeting, believing the market is overpricing the reaction. The meeting delivers a surprise and the index jumps. The firm's risk manager forces him to close the trade at a loss that eats several weeks of profits.
Example
A private investor reads about the strategy online and sells a straddle on a volatile technology stock without understanding the margin. When the stock gaps up 20%, his broker issues a margin call for more cash. He learns that the premium he collected was small compared with the loss.
Formula
Calculation
Maximum profit = total premium received x 100 shares per contract
Upper break-even = strike price + total premium per share
Lower break-even = strike price - total premium per share
Suppose a trader sells a $100 call for $4.00 and a $100 put for $3.50 on a stock trading at $100. The total premium is 4.00 + 3.50 = $7.50 per share, which is 7.50 x 100 = $750 for one contract of each, and this is the maximum profit. The upper break-even is 100 + 7.50 = $107.50 and the lower break-even is 100 - 7.50 = $92.50. If the stock finishes at $115 the call loses (115 - 100) x 100 = $1,500, and after the $750 premium the net loss is $750.Case study
Seen in the real world.
Greystone Options Desk is an illustrative, fictional trading team at a small brokerage. Its head trader sold ten short straddles on a pharmaceutical company, collecting $6.00 per share, or $6,000 in total premium, because he believed the market was overpricing an upcoming regulatory decision.
The regulator approved the drug and the shares jumped 18%. The call side lost heavily, and the loss on ten contracts far exceeded the $6,000 collected.
After the loss, the desk's risk policy changed. Every short straddle now needs a protective long option position, or a firm cap on size. The illustrative lesson is that the best case is small and known, while the worst case is large, and position sizing has to reflect that.
Watch out
Common mistakes.
- Selling a straddle just before a major event, when a large price move is most likely.
- Focusing on the premium collected without calculating the loss on a large move.
- Forgetting the margin requirement, which can rise quickly and force the position to be closed at a bad moment.
Questions
People also ask.
When does a short straddle make money?
It profits when the stock finishes between the two break-even prices, and it earns the most if the stock finishes exactly at the strike.
Is the risk limited?
No, the loss on the call side is theoretically unlimited, and the loss on the put side is large, which is why many traders add long options for protection.
How is it different from a long straddle?
A long straddle buys both options and profits from a big move, while a short straddle sells both and profits from calm.
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