This is a way to profit from a belief the market is going to go broadly nowhere in the timescale of the trade. But it is very important to understand that the risk profile of the short straddle is the very opposite of buying a straddle. With the short straddle, profit is limited and risk is potentially unlimited.
When I used to hold the payrolls webinars, I would do an options trade on the Dow selling the daily straddle. This was banking on the market ending the day broadly unchanged from where it was prior to the payrolls being announced, and allowing for a bit of volatility in between. In the words of Anchorman "60% of the time, it works every time". It actually worked more than that - but when it went wrong it could go horribly wrong, so it is by no means a “do it and forget about it” trade.
I will use the numbers from the previous blog post.
It's the beginning of January and the FTSE100 is 6725. You are expecting some volatility over the next six weeks but not a massive amount. What you do think is that the FTSE will be broadly unchanged in the middle of Feb - still trading around the 6725 levels. One way of trying to take advantage of this is by selling the straddle - sell the FEB 6725 put and the call. Here are some made-up prices for this example:
Feb 6725 put 105/110
Feb 6725 call 105/110.
I have kept the prices the same to make it easier for me - this is just an example of course. If you are buying you would buy at 110, if selling then 105. So, the total “received” for selling the Feb 6725 FTSE straddle in this example is 210 (105+105). Let's assume you sell £5 a point.
Short the 6725 straddle for 210 makes it very easy to calculate the breakeven at expiry.
Upper limit: 6725+210= 6935
Lower Limit: 6725-210= 6515
The market needs to be below 6935 and above 6515 at expiry to yield some sort of profit. So that’s a 420 point range that will deliver a profit of varying degrees in this example with, of course, maximum profit if the market expires at 6725, right on the strike.
There are lots again. The ideal one is very little happens and the market ends up as near as possible to the strike price of 6725. Options expiry for the FTSE is usually the third Friday of the month. Of course, YOU DO NOT HAVE TO HOLD THE OPTIONS TO EXPIRY. But for the purposes of this we will assume you let it run to the bitter end.
Outcome 1 - Flat Market
Happy days. The market spends the next few weeks just flipping around - up one day and down the next. The FTSE expires at 6750, only 25 points away from where the trade was opened and the strike price of the straddle. The put is worthless - it gives the right to sell at 6725, but the market is at 6750, so why would you want that? So the put expires at zero, and it was sold for 105. The call still has some value - it gives the right to buy at 6725 and the market is 6750 - so the call is worth 25. But this was also sold at 105, so profit here.
The value of the straddle at expiry is 25 points in total (the values of the put and the call). It was sold for 210 so the overall profit is 210-25= 185 points. At £5 per point that is £925, for a market that went nowhere.
This is pretty much the ideal outcome. If the market really does spend six weeks hardly moving, almost every day the value of the straddle will be dropping, notching up a little bit of profit. Unfortunately, in the real world, markets seldom spend weeks and weeks doing nothing - there is usually the odd scare along the way for options sellers.
Outcome 2 - Small-ish Market Move
It ends up being a quiet few weeks, but the market has dropped by 100 points by the time of expiry, leaving the FTSE at 6625. The call option gives the right to buy at 6725 - but the market is 6625 so that is worthless. The put gives the right to sell at 6725 - with the market at 6625 the put has a value of 100. So the straddle value at expiry is 100 + 0. The profit is 210-100= 110, which at £5 per point translates into a profit of £550. So, even though the market moved 100 points away from the strike price, the straddle still makes a profit.
Outcome 3 - Large Market Move
This is the worst outcome for the short straddle. The whole idea for a short straddle is a market where volatility does not increase and at expiry the market is as near as possible to the strike price for maximum profit. Let’s assume this doesn’t happen and the market goes up every day and at expiry is at 7225 - 500 points away from the strike. The put is worthless but the call, giving the right to buy at 6725 is worth 500. So the straddle is 500 at expiry. The loss in this example is 210-500 = -290. At £5 per point it’s a loss of £1,450.
Of course, if things start going wrong and the market starts moving there are always some alternative actions available. You could just throw the towel in and close the straddle, realising the loss. Or you could look to hedge the move by buying the underlying market - in this example, buying the FTSE at £5 per point would mitigate the loss made on the short call. And then look to take the hedge off when you think the move has run its course. Easier said than done of course and forces us to take a directional view on the market when the whole idea of straddles is a more balanced approach.
It is important to not underestimate the risk in the short straddle - if the market experiences a strong move it can end up being very similar to a normal trade where you are just positioned the wrong way. There is no such thing as free money.