Asio Investment Tools  
Home Fundamentals Neutral Strategies Short Straddle Strategy
 

Generate Income,Trade Options Like a ProGo To Options Analysis Software

  
 

Options Strategies Straddles

  
 

A word on market-makers’ point of view on straddles. Market-makers and professional traders use the straddle information as an indicator of how much up or down the market expects the specific underlying asset will move in the very near future.

Let us say a company with stock symbol XYZ is planning to report its earnings in few days. Now we will check the straddle price. The premiums paid for buying the call and the put contracts is X dollars. With the time closing to the reporting day they see the straddle price is usually inflated because the market expects the underlying to move up or down more than the straddle price. Certainly, market-maker will prefer to sell straddles as high as possible and hope to be on the safe side and the straddle price will stay in the limits of the expected movement.

Example
Let us say XYZ is trading in the market at a price of $72.30. The straddle price is $4.20, this means that the market expects the stock to move more than 4.2 / 72.3 = 5.8% up or down.

Sometimes the market predicts movement correctly and sometimes not. Market-makers do not take too many chances and try to sell at a higher price with historically lower probability to exceed these numbers. This also called selling premium to the highest bidder and selling volatility as high as possible.

The crowd on the other side buys calls and/or puts according to their analysis, and they pay a bundle of a premium and there is a chance that the entire profit from the movement will be offset by the decline in IV or premium. Statistically most of the premium sold to the market stays with market-makers, but it is okay because they take the chance to be wrong from time to time and pay a lot of money back to the market.

Short Straddle Strategy

Short straddle strategy description: Sell ATM put and call strikes. This strategy's outlook for the financial instrument is a converging volatility in the short term. According to its typical characteristics, it will greatly gain value through time decay and implied volatility value decrements. At expiration, if eventually both contracts strike price are equal to the financial asset’s price, the setup will end up worthless and total premium received will remain with the premium seller.

Typically, with this setup's category, you must stay away and not enter into a trade just before critically earnings report, FDA approvals or disapprovals, or major macro index that will have a dramatic influence on the movement of the underlying asset, unless you are definitely sure that the underlying instrument will not exceed the straddle's value.

Prospect direction: The stock will be short-termed neutral, considering duration advantage because of time decay. Implied volatility advantage or disadvantage, as you already know that, when financial instrument declines normally its IV value will increase and for this strategy, it is bad news and good news if the opposite happens.

Profit potential: Limited to a premium received for both contracts.

Loss potential: Theoretically unlimited, since the underlying instrument can move at least infinitely upwards and to zero downwards.

Risk reward: Unlimited risk divided by the premium received.

Breakeven point at expiration: If the underlying asset is higher than the options strike price then underlying price - premium received - options strike price = zero. Or, if underlying asset is lower than the options strike price, underlying price + premium received - strike price = zero.

Time factor: For this setup, timing is very crucial. Both options are short and certainly time decay will be double. Every day with no abrupt movement in the underlying asset, the losses from time decay will increase the chances to win this trade.

Implied volatility: Typically, an increase in implied volatility would negatively affect this strategy, all other variables being equal. Volatility tends to boost the value of any options, because it indicates a greater statistical probability that the stock will move enough to give the option intrinsic value by the expiration day. On the other hand, a decline in volatility has a tendency to lower option's value, regardless of the overall stock price trend.  One more thing about IV entering to a trade choosing high underlying asset's IV will increase the time decay income that will offset for a sharper move either way, the market in pricing in this future movement.

  
 

 
 

Straddle strategy is unique; some of the market-makers are using this strategy in times when implied volatility is high, and they expect volatility to converge. You can execute straddle with options only or combined with the underlying asset, in this chapter will elaborate few of its implementations.

Typical Straddle Setup
1. Sell ATM put and call options. Do not enter just before any critical announcement when there is a good chance for an abrupt move and there is a possibility that IV will increase a week or so before this critical announcement. You should not consider entering at that point. A rise in the IV will boost options prices. Sometime IV tends to rise before the news enough to incur an enormous loss that will not offset that income from time decay.

2. Sell ATM put and sell equal delta amount in underlying assets. This setup is suitable for ‘delta hedging’ keeping the position in delta neutral it is also called as ‘volatility selling’. Both actions are designed to gain from the conversion underlying asset movement and implied volatility.

Directional Straddles
1. Sell OTM Put and ITM Call options - bearish. This strategy is bearish biased, positioning with ‘Negative Deltas’ letting the downside to be favored, also with lesser time decay income. The put option will gain more than the call's incurred loss. If the underline asset goes counter to the preferred direction, delta value will continue to decrease and incur losses.

2. Sell ITM put and OTM call options - bullish. This strategy is bullish-biased, positioning with ‘positive deltas’ and letting the upside gain more, also with lesser time decay income. The call option will gain more than the put’s incurred loss. If the underlying asset goes counter the preferred direction, delta value will continue to increase and incur losses.