The short straddle is dangerous because, well for one thing, both sides are short. Making things even riskier, one side or the other is always in the money.
Even so, the true risk of the short straddle might not be as severe as traders often assume. Consider how much risk is reduced in the following circumstances:
1. Premium is very rich. The best short straddles (a short straddle is selling a call and put on the same underlying, same strike and same expiration) are those that, given the at-the-money or -near-the-money conditions, offer overall very rich premium. For example, at the close of trading Tuesday, July 24, 2012, Apple (AAPL) closed at $600.92. The AAPL July Weekly options — with the last trading day only three days away — showed the 600 calls were 17.20 bid and the 600 puts could be sold at 16.35. That’s a 33.55-point credit before commissions – pretty rich with only three days to go. Of course, the post-close earnings announcement indicated a likely open the next day at 570, but even with a 30-point decline, you’re still ahead by collecting a 33.55 point credit. Even exercise of the short put would net out at a profit; and the position could also be rolled or closed before Friday.
2. Expiration takes place in one month or less. As in the case of Apple, what happens to that 33.55 points by Friday? One of the two options is going to decline rapidly just because it will be OTM, and the other is likely to see time decay that could well match the intrinsic side. Even if it lags, 33.55 points is a lot of wiggle room.
3. You plan to close both sides once time decay starts to hit; or if intrinsic value moves too quickly, you plan to roll forward (up in strike with the short call or roll down with the short put) and duplicate the strategy. The forward roll is another likely possibility. These options are so rich that rolling can be net profitable at least until enough time decay catches up and lets you close at a profit. But lets look at Apple this morning 90-minutes into the trading day. AAPL was trading at $574.70. The short 600 strike is $25.30 In-The-Money and could be closed at $25.60. The short 600 strike call was offered at $0.07, so the position could have been closed at $25.67. AAPL has moved down ~$26, we were short the 600 straddle, and we could close the position for an ~$8 profit.
4. You also plan to cover the short call or put if circumstances make it necessary. You can cover with stock or long options, although that’s an expensive proposition. The attractive shorts usually have a correspondingly expensive long, so cover with long options is not the best way out of the straddle.
5. You are willing to get exercised as long as it nets out to a profit for you. The case of Apply demonstrates that exercise can be a good thing. As long as the market value in within the 33.55-point range above or below the 600 strike ($566.45 is the downside break-even), the outcome is still profitable.
Even though these numbers look like the idea can work out, remember the one rule about short combinations: Even when they work on paper and even when they should work in practice, they can also go wrong, expensively and quickly. If you’re going to do short straddles, keep them within sight of expiration and be willing to accept the risks. Also make sure you have the equity to meet margin requirements. At the $600-per-share level, these short options can be expensive even on margin. One last item: Since this position includes two short option positions, make sure you are approved for this type of trade.
Michael C. Thomsett
About this week’s Heavy Hitter: Michael C. Thomsett is a widely published options author. Thomsett blogs at FT Press, Benzinga, Global Risk Community and Seeking Alpha. Michael’s website isThomsettOptions Twitter:Twitter