Series 65
Textbook
2.4.1.15 Short straddles
Short straddles are essentially the opposite of long straddles. In the previous chapter, we learned how long straddles are profitable if the market is volatile. Conversely, short straddles are profitable if the market is flat (neutral).
These are the components of a short straddle:
Short call & short put*
*Must be the same strike price and expiration
For example:
Short 1 ABC Jan 60 call
Short 1 ABC Jan 60 put
As you already know, a short call results in the obligation to sell, while a short put results in the obligation to buy. The short call is bearish, providing a return if the market price stays at $60 or below. The short put is bullish, providing a return if the market price stays at $60 or above. An investor that sells both options bets on market neutrality.
If the stock’s market price stays flat, both options may expire worthless. This would only occur if ABC’s market price was the same as the shared strike price, the best-case scenario for a short straddle.
If the stock’s market price rises, the investor’s call will be assigned (exercised). This scenario presents the investor with the most risk as the call obligates the investor to sell shares at the strike price. Before this occurs, the investor must purchase the shares at the market price. The higher the market price rises, the more expensive it is to acquire the shares (and the larger the loss).
If the stock’s market price falls, the investor’s put will be assigned (exercised). This scenario presents the investor with significant risk as the put obligates the investor to buy shares at the strike price. The further the market price falls, the more the investor “overpays” for the stock (and the larger the loss).
On the surface, a short straddle seems like a risky strategy - and it certainly is. With two naked (uncovered) options, the risk potential is significant. However, two premiums are received to establish this strategy. Therefore, the losses on either option must exceed the combined premiums for the investor to experience an overall loss. The investor will likely profit if the stock’s market price doesn’t move dramatically.
Let’s take a look at several scenarios to understand short straddles better:
An investor goes short 1 ABC Jan 60 call at $4 and short 1 ABC Jan 60 put at $5 when ABC’s market price is $60. What is the gain or loss if ABC’s market rises to $120?
Can you figure it out?
Answer = $5,100 loss
| Action | Result |
|---|---|
| Sell call | +$400 |
| Sell put | +$500 |
| Buy shares | -$12,000 |
| Call assigned - sell shares | +$6,000 |
| Total | -$5,100 |
At $120, the call is “in the money” (has intrinsic value) and the put is “out of the money” (no intrinsic value). The put expires worthless, but the call is assigned (exercised), requiring the investor to fulfill their obligation to sell. The stock is first purchased in the market at $120, then sold at $60, netting a $60 loss per share or $6,000 overall ($60 x 100 shares). The $900 combined premium received upfront reduces the loss to $5,100.
The investor was hoping for a flat market, and they got the opposite. A market swing of $60 upwards is significant (a 100% increase). While only one option went “in the money,” the call created a significant loss. The premiums offset the loss slightly, leaving the investor with a substantial overall loss.
The maximum loss for a short straddle is unlimited. The further the market rises, the larger the loss because of the short naked call.
What happens if the market rises a moderate amount?
An investor goes short 1 ABC Jan 60 call at $4 and short 1 ABC Jan 60 put at $5 when ABC’s market price is $60. What is the gain or loss if ABC’s market price rises to $69?
Answer = $0 (breakeven)
| Action | Result |
|---|---|
| Sell call | +$400 |
| Sell put | +$500 |
| Buy shares | -$6,900 |
| Call assigned - sell shares | +$6,000 |
| Total | $0 |
At $69, the call is “in the money” (has intrinsic value) and the put is “out of the money” (no intrinsic value). The put expires worthless, but the call is assigned (exercised), requiring the investor to fulfill their obligation to sell. The stock is first purchased in the market at $69, then sold at $60, netting a $9 loss per share or $900 overall ($9 x 100 shares). The $900 combined premium received upfront offsets the loss, resulting in breakeven.
While the call gained intrinsic value, it didn’t gain enough to offset the initial premiums received. $69 is one of two breakevens for this example (we’ll discuss the other breakeven later). The call must lose an amount equal to the combined premiums for the straddle to break even on the upside. Therefore, the upside breakeven for a straddle (long or short) can be calculated by adding the combined premium ($9) to the shared strike price ($60).
What happens if the market rises slightly?
An investor goes short 1 ABC Jan 60 call at $4 and short 1 ABC Jan 60 put at $5 when ABC’s market price is $60. What is the gain or loss if ABC’s market price rises to $64?
Answer = $500 gain
| Action | Result |
|---|---|
| Sell call | +$400 |
| Sell put | +$500 |
| Buy shares | -$6,400 |
| Call assigned - sell shares | +$6,000 |
| Total | +$500 |
At $64, the call is “in the money” (has intrinsic value) and the put is “out of the money” (no intrinsic value). The put expires worthless, but the call is assigned (exercised), requiring the investor to fulfill their obligation to sell. The stock is first purchased in the market at $64, then sold at $60, netting a $4 loss per share or $400 overall ($4 x 100 shares). The $900 combined premium received upfront offsets the loss, resulting in a $500 gain.
A flat market is what a short straddle investor hopes for. While the stock’s market price increased by $4 per share, the assignment (exercise) losses didn’t exceed the combined premiums received upfront. The closer the stock’s market price stays to the shared strike price, the more likely the investor profits.
What happens if the market remains flat?
An investor goes short 1 ABC Jan 60 call at $4 and short 1 ABC Jan 60 put at $5 when ABC’s market price is $60. What is the gain or loss if ABC’s market price stays at $60?
Answer = $900 gain
| Action | Result |
|---|---|
| Sell call | +$400 |
| Sell put | +$500 |
| Total | +$900 |
At $60, both options are “at the money,” resulting in each expiring worthless (contracts must have intrinsic value to be exercised). The result is an overall gain of $900 (combined premiums).
While unlikely, the market could stay exactly at $60 per share. This is the “best case scenario” for the investor as they experience the maximum gain.
The maximum gain for a short put can be found by using this formula:
What happens if the market falls a small amount?
An investor goes short 1 ABC Jan 60 call at $4 and short 1 ABC Jan 60 put at $5 when ABC’s market price is $60. What is the gain or loss if ABC’s market price falls to $59?
Answer = $800 gain
| Action | Result |
|---|---|
| Sell call | +$400 |
| Sell put | +$500 |
| Put assigned - buy shares | -$6,000 |
| Share value | +$5,900 |
| Total | +$800 |
At $59, the put is “in the money” (has intrinsic value) and the call is “out of the money” (no intrinsic value). The call expires worthless, but the put is assigned (exercised), requiring the investor to fulfill their obligation to buy. Shares are purchased for $60 when they’re only worth $59, creating a $1 loss per share or $100 overall ($1 x 100 shares). The $900 combined premium received upfront completely offsets the loss, resulting in an overall gain of $800.
Again, a flat market is what a short straddle investor hopes for. While the stock’s market price fell by $1 per share, the assignment (exercise) losses didn’t exceed the combined premiums received upfront. The closer the stock’s market price stays to the shared strike price, the more likely the investor profits.
What happens if the market falls a little further?
An investor goes short 1 ABC Jan 60 call at $4 and short 1 ABC Jan 60 put at $5 when ABC’s market price is $60. What is the gain or loss if ABC’s market price falls to $51?
Answer = $0 (breakeven)
| Action | Result |
|---|---|
| Sell call | +$400 |
| Sell put | +$500 |
| Put assigned - buy shares | -$6,000 |
| Share value | +$5,100 |
| Total | $0 |
At $51, the put is “in the money” (has intrinsic value) and the call is “out of the money” (no intrinsic value). The call expires worthless, but the put is assigned (exercised), requiring the investor to fulfill their obligation to buy. Shares are purchased for $60 when they’re only worth $51, creating a $9 loss per share or $900 overall ($9 x 100 shares). The $900 combined premium received upfront completely offsets the loss, resulting in breakeven.
While the put gained intrinsic value, it didn’t gain enough to offset the initial premiums received. $51 is the other breakeven for this example. The put must lose an amount equal to the combined premiums for the straddle to break even on the downside. Therefore, the downside breakeven for a straddle (long or short) can be calculated by subtracting the combined premium ($9) from the shared strike price ($60).
Here’s the general formula for breakeven on straddles:
The breakeven formula is the same for both long and short straddles.
Straddles are one of the only options strategies with multiple breakevens. To find both quickly, first add up the combined premiums. Next, add and subtract the combined premiums to and from the shared strike price. In summary, the two breakevens for this long straddle are $51 and $69.
What happens if the market falls significantly?
An investor goes short 1 ABC Jan 60 call at $4 and short 1 ABC Jan 60 put at $5 when ABC’s market price is $60. What is the gain or loss if ABC’s market price falls to $25?
Answer = $2,600 loss
| Action | Result |
|---|---|
| Sell call | +$400 |
| Sell put | +$500 |
| Put assigned - buy shares | -$6,000 |
| Share value | +$2,500 |
| Total | -$2,600 |
At $25, the put is “in the money” (has intrinsic value) and the call is “out of the money” (no intrinsic value). The call expires worthless, but the put is assigned (exercised), requiring the investor to fulfill their obligation to buy. Shares are purchased for $60 when they’re only worth $25, creating a $35 loss per share or $3,500 overall ($35 x 100 shares). The $900 combined premium received upfront reduces the loss to $2,600.
The investor was hoping for a flat market, and they got the opposite. A market swing of $35 downward is significant (a 58% decrease). While only one option went “in the money,” the put created a significant loss. The premiums offset the loss slightly, leaving the investor with a substantial overall loss.
Let’s look at the options payoff chart to summarize the “big picture” of this short straddle. First, let’s re-establish the example:
Short 1 ABC Jan 60 call @ $4
Short 1 ABC Jan 60 put @ $5
Here’s the payoff chart:
The horizontal axis represents the market price of ABC stock, while the vertical axis represents overall gain or loss.
As the short straddle payoff chart shows, the investor reaches their maximum gain of $900 at a market price of $60. At this point, both options expire worthless, and the combined premiums represent the overall gain. If the market price rises above or falls below $60, the call or the put goes “in the money” and gains intrinsic value. Remember, option writers (sellers) experience losses when their contracts gain intrinsic value. Intrinsic value is good for the holder (buyer, long side) and bad for the writer (seller, short side).
If the market price rises to $69, the short call gains $9 of intrinsic value, offsetting both premiums. Any market price above $69 results in a loss as the investor is subject to unlimited loss potential. If the market price falls to $51, the short put gains $9 of intrinsic value, offsetting both premiums. Any market price below $51 results in a loss as the investor is eligible for up to $5,100 of liability (a $5,100 loss would occur if the market price falls to $0).
In our last few examples, let’s explore what happens if investors close out contracts at intrinsic value. As we’ve learned previously, closing out contracts involves trading the contracts instead of waiting for assignment or expiration.
An investor goes short 1 ABC Jan 60 call at $4 and short 1 ABC Jan 60 put at $5 when ABC’s market price is $60. ABC’s market price falls to $40 and the investor closes the contracts at intrinsic value. What is the gain or loss?
Answer = $1,100 loss
| Action | Result |
|---|---|
| Sell call | +$400 |
| Sell put | +$500 |
| Close call | $0 |
| Close put | -$2,000 |
| Total | -$1,100 |
At $40, the put is “in the money” (has intrinsic value) and the call is “out of the money” (no intrinsic value). The call has $0 of intrinsic value, and the investor closes the call by buying it for $0 (closing purchase). The put has $20 of intrinsic value, and the investor closes the put by buying it for $20 (closing purchase). The $9 premium received upfront compared to closing the put for $20 results in an $11 per share loss, or $1,100 overall ($11 x 100 shares).
As a reminder, closing contracts involves doing the opposite transaction performed upfront. In this scenario, two options were sold to create the short straddle (opening sales). To close both options, they’ll need to be bought (closing purchases). After selling $900 of options and buying to close for $2,000, the investor ends with a $1,100 loss.
Let’s examine one more scenario involving closing transactions for our last example:
An investor goes short 1 ABC Jan 60 call at $4 and short 1 ABC Jan 60 put at $5 when ABC’s market price is $60. ABC’s market price rises to $67 and the investor closes the contracts at intrinsic value. What is the gain or loss?
Answer = $200 gain
| Action | Result |
|---|---|
| Sell call | +$400 |
| Sell put | +$500 |
| Close call | -$700 |
| Close put | $0 |
| Total | +$200 |
At $67, the call is “in the money” (has intrinsic value) and the put is “out of the money” (no intrinsic value). The put has $0 of intrinsic value, and the investor closes the put by buying it for $0 (closing purchase). The call has $7 of intrinsic value, and the investor closes the call by buying it for $7 (closing purchase). The $9 premium received upfront compared to closing the call for $7 results in an $2 per share gain, or $200 overall ($2 x 100 shares).
Similar to the previous example, two options were sold to create the short straddle (opening sales). To close both options, they’ll need to be bought (closing purchases). After selling $900 of options and buying to close for $700, the investor ends with a $200 gain.
This video covers the important concepts related to short straddles:
For suitability, short straddles should only be recommended to aggressive options traders with a substantial net worth if a flat market is expected. If there is unexpected volatility, the investor is subject to unlimited risk. The fewer assets or money an investor has, the less likely they should be selling straddles.
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