by Thomas DeMark
Short Straddle
In a short straddle, the trader believes the market will consolidate or move sideways into the options’ expirations. A short straddle entails the simultaneous sale of a call option and a put option of the same security, strike price, and expiration date. The short call option allows the trader to gain if it expires at-the-money, and the short put option allows to trader to gain if it also expires at-the-money; if the market either advances or declines, then the trader loses the amount by which the option is in-the-money. Since the trader is selling both a call and a put, the trader initially receives the full option premiums for both contracts, making this a credit straddle. Because he or she is taking on more risk by selling both options, the trader receives a larger premium. To obtain the break-even points of a short straddle, one would add the net payment received on the straddle to the short call option’s strike price and subtract the net payment received on the straddle from the short put option’s strike price – anything above the upper (call option’s) break-even point would be a loss and anything below the lower (put option’s) break-even point would be a loss. Any price in between these two levels would be a gain. The maximum gain for a short straddle is the initial premium income the trader receives for selling the options, while the maximum loss for a short straddle is unlimited.
Example:
Sell 1 Exxon (XON) June 70 Call @ 4
Sell 1 Exxon (XON) June 70 Put @ 3
Market Price of Exxon Stock: $70
In this example, the trader has initiated a short straddle since the security, the strike prices, and the expiration months are all the same. Here, the trader has sold one Exxon call option with a June expiration and a $70 strike price for $400 and has sold one Exxon put option with a June expiration and a $70 strike price for $300, when Exxon is trading at $70 per share. Therefore, the total premium received by the option writer on the straddle is $700. This is a nonrefundable, fixed income payment and cannot be lost. This $700 is also the most the seller can make on the transaction – if both the call and the put option were to expire at-the-money, meaning Exxon stock were trading at $70 per share, the trader would owe nothing and keep the $400 on the long June 70 call and the $300 on the long June 70 put. Therefore, the trader would ideally like to see the market move sideways.
If Exxon stock were trading at $75 per share, the trader would lose $500 on the short June 70 call position that is in-the-money, lose nothing on the short June 70 put that is out-of-the-money, and make $700 for the fixed cost to initiate the straddle, for a net gain of $200. If Exxon were trading at $65 per share, the trader would lose nothing on the short June 70 call that is out-of-the-money, lose $500 on the short June 70 put that is in-the-money, and make $700 for the fixed cost to initiate the straddle, for a net gain of $200. Please note that a short straddle is simply made up of two regular option contracts. Therefore, if Exxon’s market price continues to move in-the-money, either upside or downside, losses continue to increase indefinitely. Short straddles differ from spreads in that the losses are unlimited.
To summarize, the most the trader could make in a short straddle would be the full premium received by initiating the straddle ($700) and this would incur if the options expired at-the-money ($70). The most the trader could lose in a short straddle is unlimited to the upside and restricted to the total value of the underlying contract if it were to decline to zero ($7,000 – $700 = $6,300) on the downside. Therefore, if the market were to move sideways, the trader will gain; however, if the market were to advance or decline, the trader will experience a loss.
Short Combination
A short combination is very similar to a short straddle. In a short combination, the trader believes the market will consolidate or move sideways into the option’s expirations. A short combination entails the simultaneous sale of a call option and a put option of the same security, but with different strike prices, different expiration dates, or both different strike prices and different expiration dates. However, short combinations with different strike prices are the most common. The short call option allows the trader to gain if it expires at-the-money or out-of-the-money, and the short put option allows the trader to gain if it also expires at-the-money or out-of-the-money; if the market either advances or declines, then the trader loses the amount by which the option is in-the-money. Since the trader is selling both a call and a put, he initially receives the full option premiums for both contracts, making this a credit combination. Because the trader is taking on more risk by selling both options, he or she gains a larger premium. To obtain the break-even points of a short combination, one would add the net payment received on the combination to the short call option’s strike price and subtract the net payment received on the combination from the short put option’s strike price – anything above the upper (call option’s) break-even point would be a loss and anything below the lower (put option’s) break-even point would be a loss. Any price in between these two levels would be a gain to the trader. The maximum gain for a short combination is the initial premium income the trader receives for selling the options, while the maximum loss for a short combination is unlimited.
Example:
Sell 1 Exxon (XON) June 75 Call @ 3
Sell 1 Exxon (XON) June 65 Put @ 2 ½
Market Price of Exxon Stock: $70
In this example, the trader has initiated a short combination since the security and the expiration months are the same, but the strike prices are different. The advantage of this short combination is that the strike prices are spaced further apart, creating a larger window for gains; however, because of the widened strike prices, the premiums that the seller receives will be lower than those for short straddles. Here, the trader has sold one Exxon call option with a June expiration and a $75 strike price for $300 and has sold one Exxon put option with a June expiration and a $65 strike price for $250, when Exxon is trading at $70 per share. Therefore, the total premium received by the option writer on the combination is $550. This is a nonrefundable, fixed income payment to the trader and cannot be lost. This $550 is also the most the trader can make on the transaction – if both the call and the put were to expire at-the-money or out-of-the-money, meaning Exxon stock were trading at $65 per share, $75 per share, or somewhere in between, the trader would owe nothing and keep the $300 on the short June 75 call and the $250 on the short June 65 put. Again, the trader would ideally like to see the market move sideways.
If Exxon stock were trading at $80 per share, the trader would lose $500 on the short June 75 call position that is in-the-money, lose nothing on the short June 65 put position that is out-of-the-money, and make $550 on the fixed cost to initiate the combination, for a net gain of $50. If Exxon were trading at $60 per share, the trader would lose nothing on the short June 75 call position that is out-of-the-money, lose $500 on the short June 65 put position that is in-the-money, and make $550 for the fixed cost to initiate the combination, for a net gain of $50. Please note that a short combination is made up of two regular option contracts. Therefore, as Exxon’s market price continues to move in-the-money, either upside or downside, losses continue to grow indefinitely. Short combinations differ from spreads in that the losses are unlimited.
To summarize, the most the trader could make in a short combination would be the full premium received by initiating the combination ($550) and this would occur if the options expired at-the-money or out-of-the-money (greater than or equal to $65 and/or less than or equal to $75). The most the trader could lose in a short combination is unlimited to the upside and restricted to the total value of the underlying contract if it were to decline to zero ($6,500 – $550 = $5,950) on the downside. Therefore, if the market were to move sideways, the trader will gain; however, if the market were to advance or decline, the trader will experience a loss.
Many possible option strategies can be utilized to anticipate price movement. Before initiating a position, it is important the trader determine the most advantageous and cost-effective strategy for his or her needs. This depends upon the individual’s trading intentions and whether he or she is trading options for hedging, income, or speculative purposes.
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