Short Straddle
Risk: high
Reward: medium
General Description
Entering a short straddle entails selling at-the-money calls and puts at the same strike price.
The Thinking
You are not bullish or bearish and you feel fairly certain the stock will not move much from its current position. You sell calls and puts and will keep most of the premium as long as the underlying issue trades sideways. But if the stock takes off in either direction your risk is huge because you have no protection.
Example
Let's say IBM is trading @ 80. You sell the 80 calls and puts for $6 each for a total cost of 12. If the stock closes at 80, both legs of the straddle will expire worthless and you keep the premium collected from both. To profit the stock must either close above 68 (80-12) or below 92 (80+12). But if the stock falls below 68 your naked put position will increase in value point for point as the stock falls, and if the stock rallies above 92 your naked call position will increase in value point for point as the stock rallies. So you need the stock to stay pretty close to home.
The image below summarizes the trade with a P/L Diagram. |
