What is a 'Short Straddle'

A short-straddle is an options strategy comprised of selling both a call option and a put option with the same strike price and expiration date. It is used when the trader believes the underlying asset will not move significantly higher or lower over the lives of the options contracts. The maximum profit is the amount of premium collected by writing the options. The potential loss can be unlimited so it is a strategy for more advanced traders only.

BREAKING DOWN 'Short Straddle'

Short straddles allow traders to profit from the lack of movement in the underlying asset, rather than having to place directional bets hoping for a big move either higher or lower. Premiums are collected when the trade is opened with the goal to let both the put and call to expire worthless. However, chances that the underlying closes exactly at the strike price at options expiration is low and that leaves the short straddle owner at risk for assignment. However, as long as the difference between asset price and strike price is less that the premiums collected, the trader will still make a profit.

Advanced traders might run this strategy to take advantage of a possible decrease in implied volatility. If implied volatility is unusually high without an obvious reason for being that way, the call and put may be overvalued. In this case, the goal would be to wait for volatility to drop and then close the position for a profit without waiting for expiration.

Example of a Short Straddle

Most of the time, traders use at the money options for straddles.

If a trader writes a straddle with a strike price of $25, for an underlying stock trading near $25 per share, and the price of the stock jumps up to $50, the trader would be obligated to sell the stock for $25. If the investor did not hold the underlying stock, he or she would be forced to buy it on the market for $50 and sell it for $25 for a loss of $25 minus the premiums received when opening the trade.

There are two potential break-even points at expiration at the strike price plus or minus the total premium collected.

For a stock option with a strike price of $60 and a total premium of $7.50, the underlying stock must close between $52.50 and $67.50, not including commissions, for the strategy to break even.

A close below $52.50 or above $67.50 will result in a loss.

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