A short straddle gives you the obligation to sell the stock at strike price A and the obligation to buy the stock at strike price A if the options are assigned.
By selling two options, you significantly increase the income you would have achieved from selling a put or a call alone. But that comes at a cost. You have unlimited risk on the upside and substantial downside risk.
Advanced traders might run this strategy to take advantage of a possible decrease in implied volatility. If implied volatility is abnormally high for no apparent reason, the call and put may be overvalued. After the sale, the idea is to wait for volatility to drop and close the position at a profit.
Maximum Potential Profit
Potential profit is limited to the net credit received for selling the call and the put.
Maximum Potential Loss
If the stock goes up, your losses could be theoretically unlimited.
If the stock goes down, your losses may be substantial but limited to the strike price minus net credit received for selling the straddle.
Break-even at Expiration
There are two break-even points:
- Strike A minus the net credit received.
- Strike A plus the net credit received.
TradeKing Margin Requirements
NOTE: The net credit received from establishing the short straddle may be applied to the initial margin requirement.
After this position is established, an ongoing maintenance margin requirement may apply. That means depending on how the underlying performs, an increase (or decrease) in the required margin is possible. Keep in mind this requirement is subject to change and is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.
As Time Goes By
For this strategy, time decay is your best friend. It works doubly in your favor, eroding the price of both options you sold. That means if you choose to close your position prior to expiration, it will be less expensive to buy it back.
After the strategy is established, you really want implied volatility to decrease. An increase in implied volatility is dangerous because it works doubly against you by increasing the price of both options you sold. That means if you wish to close your position prior to expiration, it will be more expensive to buy back those options.
An increase in implied volatility also suggests an increased possibility of a price swing, whereas you want the stock price to remain stable around strike A.