What is a Short Straddle & How to Trade?

A short straddle is an undefined risk options strategy that involves selling an at-the-money call and put with the same expiration and strike. Watch Mike give this introduction covering what a short straddle is and how it works.

Hey guys welcome back to mike and his whiteboard my name is mike this is my whiteboard and today we’re going to be talking about a tasty trade tasty trade strategy which is the straddle so yesterday we talked about standard deviation and how we can use that with our option strategies today we’re going to go back into strategies and discuss a straddle which is

Essentially the sale of a put and a call on the same strike and same expiration so it’s one of the best undefined risk strategies that we like to use so when we look at the first slide here we’re going to break down how a straddle is profitable so when we look at this graph we’ve got a one twenty strike and you can see below the strike bar we have a put in a call

In the november expiration now when you look at the dollar value above that you can see that we actually have a range of profitability so this is defined as a neutral strategy so you can see that the above the dollar sign we have the dotted line and the dotted line is highest when we’re at the money and that’s because the at the money strike and the at the mony

Options have the most extrinsic value and that’s where we’re getting this large sale from so at expiration if we actually pin that strike and the stock price is at 120 we’re going to make max profit because if the stock is literally at 120 point zero zero both of those options will be considered out of the money because they’re not one penny in the money either

Way so this is how a straddle is going to look when we’re looking at a traditional risk graph and where the profitability is going to lie but if we look at the next slide here we can see what sort of example we can look at when we’re looking at how we can be profitable and what sort of ranges we can be profitable in so when we have a look at the next slide here

We’ve got a credit of 850 in the upper right corner and we have the same sort of risk graph that we were using before we are looking at the same put and call on the 120 strike but now we broken it out to give you a sense of what sort of credit we might be getting for each of these options so we’re essentially assuming that there is a normal volatility skew here

Which is why we’re receiving more for the put than we are for the call so if we’re looking at the put we’ve got 455 and credit and when we look at the call we’ve got 395 and credit which is giving us that total of $8.50 credit that we’re taking in so when we’re looking at different examples here we’re basically looking at the stock at expiration so if the stock is

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At 116 at expiration we would be profitable to the tune of four hundred and fifty dollars now how am i getting that number well essentially what i’m knowing is that either the put or the call is going to be in the money at a certain point in time so if the stock is at 116 that means that the put is in the money now remember when we sell a put we have the right

To essentially buy the shares at a certain strike so when i sell a put i’m basically selling the other person the right to sell me their shares it’s a little confusing but once you get that down it makes a lot more sense so when we’re selling the put if the stock price is below our strike that means that they can now sell the shares at 120 even though the stock

Is trading at 116 so that gives the put intrinsic value and that’s why that put is in the money so at expiration we would have to buy back that put for four dollars so the strike is at 120 the stock price is at 116 so that’s four dollars difference so we’re gonna have to buy that back for four dollars now if we took in $8.50 originally if we only have to buy back

The put for four dollars because the call is out of the money and worthless essentially what we do is take that 850 subtract the four dollars we have to buy back the put 4 and that gives us our profit of 450 now if we’re looking at a different example let’s say the stock is at 125 at expiration now the calls going to be on the money so the stock price is going to

Be above our strike which is 120 and we’re going to have to buy back that call for five dollars so doing the same example as before we’re basically taking the $8 and 50 cent credit subtracting subtracting the $5 in the money value for the call that we’re going to have to buy back which gives us that profit of 350 there now what things to note about straddles is

That one of the things is that one option will always be in the money so unless the stock price is at exactly 120 point zero zero it’s going to be in the money either way so if it’s below the stock price then the puts going to be in the money and if it’s above the strike price then the calls going to be in the money so it’s important to keep note of that as the

Trade goes along the next thing to keep note of is that we like to manage these around 25 percent so again since this is a neutral strategy and it’s undefined risk and we’re trying to pin a strike essentially even though we have a wide range to be profitable essentially to get max profit we need to pin that strike so if we can capture 25 or 30 percent of this credit

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That we’ve received pretty quickly then we’re going to be happy to close the trade so let’s look at the next strike the next slide here and we’ll see what we’re looking at in terms of when we use this strategy so the very first thing is we’re going to be looking for high iv rank so we talked about iv before and essentially when we sell iv that’s going to basically

Mean that the prices are inflated and if we are selling this option or these options at a high iv we hope for implied volatility to deflate or decrease which is going to allow us to buy back the spread at a lower price so again if i can sell this bread for 850 let’s say the stock price is at 120 and i sold this for 850 now if implied volatility contracts maybe

I can buy back the same spread for 6 dollars which is going to give me a profit of $2.50 so this can be considered an implied volatility play as well so this is one thing that we’re going to look at when we’re using this strategy now the next thing is again it’s a neutral assumption so if i’m looking to add occurrences to my portfolio in a neutral manner i might

Look at something like a straddle or a strangle or an iron condor as long as we have these pretty much centered and especially in this scenario we would want to be selling it right on the stock price with the same strike price so we’re going to look at the at the money options it’s going to give me a pretty neutral profit range so these two things are pretty much

Things that we look for when we use this strategy two things i’m going to be aware of when i’m placing this strategy is that there’s constantly going to be in the money options so again unless the stock price is that exactly 120 point zero zero in the examples before one of these options is going to be in the money and the reason why this is important to be aware

Of is simply because of assignment risk now assignment risk is essentially when we’re selling something we’re giving the other person the right to exercise that contract so although assignments pretty rare it’s definitely something to keep in mind because we have a certain buying power reduction which we actually talked about in a previous whiteboard which you can

Actually look for if you click on find shows and then scroll down to mike and his white board it’ll definitely be there but when we’re looking at buying power reduction if i have a straddle on it’s going to give me one buying power reduction but now if one of the options are both of the options are exercised i’m either going to be long shares or short shares at

The certain strike price so if i now become long shares or short shares that buying power reduction is going to change so the risk profile of this trade is going to be the same but the buying power reduction can change so it’s always important to note that when we’re dealing with naked options like this buying power reduction and just being aware of assignment is

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Crucial now let’s go to the next slide and we’ll wrap up the takeaways for the straddle so the very first takeaway is that a straddle is similar to a strangle but options share the same strike price so again when we were talking about strangles it’s essentially the same thing we’re selling it out of the money put and out of the money call but they’re on different

Strike prices so we have an out of the money put and out of the money call same expiration but different strike prices so it’s also going to be an undefined risk neutral strategy with a pretty wide breakeven point on either side but it’s going to have a higher probability of touch in terms of the options not being touched by the stock price because we’re not sharing

That that strike at the at the money options we have out of the money options so we’re giving ourselves a little more leeway in terms of either option going in the money the next takeaway here is that max profit is realized that the stock pins the short strike at expiration so again unlike the strangle which is where we’ve got to out of the money options and we

Have a wide range where the stock price can move we’re collecting a much larger credit because we’re selling to at the money options so we still have a profit range in that same sense but our max profit is only going to be realized if the stock price pins our short strike at expiration and last but not least we like to manage these early if we can so if we find

An opportunity to sell a straddle at a very high iv rank and then maybe a couple days later or a week later the implied volatility comes down or just the juice and the options comes out and we can buy that back for a lower price we like to usually manage these a little sooner just because we’re going to have one option that’s pretty much going to be in the money

At a certain time during this trade so just to mitigate our risk and manage our winner we’re going to look for that opportunity whenever we can get it so this has been the straddle hopefully you enjoyed it thanks so much for tuning in if you’ve got any questions at all shoot me an email at support at doe comm or support at tastytrade.com or you can tweet us at doe

Trading at doe trader mike or at tastytrade thanks so much and we’ll see you tomorrow hey everyone i hope you liked this video click below to watch more videos subscribe to our channel or go to our website

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What is a Short Straddle & How to Trade? By tastytrade