A short straddle is a position that is a neutral strategy that profits from the passage of time and any decreases in implied volatility. The short straddle is an undefined risk option strategy.
Directional Assumption: Neutral
- Sell ATM Call
- Sell ATM Put
Ideal Implied Volatility Environment : High
Max Profit: Credit received from opening trade
How to Calculate Breakeven(s):
- Downside: Subtract initial credit from Put strike price
- Upside: Add initial credit to the Call strike price
With straddles, it is important to remember that we are working with truly undefined risk in selling a naked call. We focus on probabilities at trade entry, and make sure to keep our risk / reward relationship at a reasonable level.
Implied volatility (IV) plays a huge role in our strike selection with straddles. The higher the IV, the more credit we will receive from selling the options. A higher credit ultimately means we will have wider breakeven points, since we can use the credit to offset losses we may see to the upside or downside. At the end of the day, a larger relative credit results in a higher probability of success with this strategy.
Our target timeframe for selling straddles is around 45 days to expiration. Our studies show this is a great balance between shorter and longer timeframes.
When do we close straddles?
The first profit target is generally 25% of the maximum profit. This is done by buying the straddle back for 75% of the credit received at order entry.
When do we defend straddles?
With premium selling strategies, defensive tactics revolve around collecting more premium to improve our break-even price, and further reduce our cost basis. With short straddles, we don’t have much wiggle room because the short options are already on the same strikes. One option is to roll the whole straddle out in time, using the same strikes. This can be done for a credit, and we will hope for the stock price to return to our short strike by the new expiration.
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