Construction: Short one call and short one put with the same strike price and same expiration month. Strike price used is normally at-the-money. The Short Straddle trader is on the opposite side of the trade of the Long Straddle trader. Because the position is sold, it always produces a credit.
Function: To take advantage of a stock entering a stagnant or low volatility trading range. Bias – neutral.
When to Use: Normally around a time away from expected news releases (i.e. earnings, FDA announcements, etc.) when you feel that the lack of news can lead to a period of stagnation. Also, good to use when you feel implied volatility is likely to decrease sharply.
Breakeven: The Short Straddle shares the same two breakeven points as the Long Straddle. The breakeven points are found by adding the straddle’s credit to the strike and subtracting it from the strike.
Maximum Gain: Profits are realized for all stock prices between the breakeven points. The maximum gain is the credit received and is realized if the stock closes at exactly the strike price.
Max Loss: Losses occur if the stock price closes outside of the breakeven points. Because there’s no maximum a stock price can climb, there’s no limit on the amount that can be lost if the stock price rises. The greater the price increase above the upper breakeven, the larger the losses. To the downside, the maximum loss is limited to the strike price minus the credit received.
Key Concepts: Because of large decay associated with this position, time sensitivity is critical. The passage of time aids this strategy, so the longer the stock remains stagnant or between the two break-even points, the better for the seller.
Example: Sell one May $50 call for $3.20, and sell one May $50 put for $3. The total credit received is $6.20 and is also the most you can make. The upper breakeven is $56.20 and the lower breakeven is $43.80. Maximum gain occurs at a stock price of exactly $50 at expiration. Losses are realized for all stock prices above $56.20 or below $43.80 at expiration. Because there’s no limit on how high a stock price can rise, there’s no upper bound on the losses that can occur as the stock price rises beyond $56.20. On the downside, if the stock price fell to zero, you’d be assigned on the $50 put – but because you received $6.20 to initiate the position, your maximum loss would be $43.80.