When the market is stable, options can be a big winner for certain option trading strategies. One of them is a short straddle. A short position like this is comprised of a short call and a short put option. straddles can earn the investor premium income right away.
To fully understand the dynamics of a straddle, it is best to understand the basic risks and rewards with selling options short.
An investor who sells short a call option is looking to make the premium income on the sale. The options trader is hoping the market declines or stays the same - thus keeping the premium earned without any obligation to the call holder. If the market rises, and the stock itself is not owned by the options investor - the person could sustain an unlimited loss. When a call option is exercised, the seller must deliver the stock at the strike price. If he does not own it, he has to buy it in the market - which will most likely be higher than the price he has to sell. A short call is part of a short straddle.
Selling puts short also generates premium income, but this trader would want the stock to rise - which allows the put to expire. The maximum gain for this investor is the premium. If the market declines, the put may get exercised. The obligation of a short put investor is to purchase the stock at the strike price. The trader will lose if this happens. Selling puts is the other part of a short straddle.
Short Straddle Strategy
The basis behind the strategy is to take advantage of what short calls and short puts can accomplish together. The straddle will earn the investor more in premium then if the options were sold on their own as single contracts. Combining these can offer the investor more profit - but carry more risk.
If someone is familiar with a particular stock and it's normal trading behavior - they can be great candidates for short straddle investing. If you are playing a stock that shows limited movement or at least limited trading movement during a particular time - a short straddle can work well. All you are looking for is for both options to expire. The premiums received is the maximum gain.
Short 1 FDG Apr 30 Call for $300 Short 1 FDG Apr 30 Put for $200
The premium gain on the straddle is $500. If the market hold steady within the points of cushion, the trader will keep the premium gain and the straddle will expire worthless. The break even points are important in this, as they are the points that the stock must stay within to keep the options from getting exercised. If this were a long straddle, the break even points would be where the trader needs the stock to break through. The break even points are the strike prices plus the combined premium for the call (35) and the strike price minus the premium for the put (25).
The loss potential on this short option position is either unlimited, if the market rises (call) or $2500, should the market decline to zero ($3000 - $500) on the Put.
Short straddles are profitable in stable or sluggish markets. When this happens, the long traders lose and short traders - including straddle players win.
See more on all Straddles
Nick Hunter is the President of American Investment Training. Their website http://www.aitraining.com offers investors and brokers with education courses, trading investment information and a free financial glossary look-up.