Order Entry: Net Credit
Ideal Environment: High IV
Profit Target: 25%
Definition: A straddle consists of simultaneously selling an ATM call and put at the same time. The trade results in net credit and is an overall neutral position. Straddles have undefined risk, so the max loss is unknown entering the trade. The strategy makes money when the underlying asset has little movement in price over the duration of the options and volatility contracts.
Sell 1 ATM Call
Sell 1 ATM Put
The max profit for a straddle is the net credit received when the trade is put on. The best case scenario is that the underlying asset price is unchanged over the duration of the options and the price settles at the strikes sold when entering the trade.
Max Profit= Net Premium Received - Commissions Paid
To calculate the breakeven stock price for the trade, use the following formulas:
Downside = Put Strike - Credit Received
Upside = Call Strike + Credit Received
Unlimited (Undefined) Risk
Straddles involve selling naked options. If the stock price has a large swing up/down, straddles lose money. The hope is that the theta decay outweighs the loss with the directional move of the underlying stock. When the underlying asset rises quickly the put is worthless but the call is ITM (the loss is determined by the value of the call minus the initial credit received). When the underlying asset falls quickly the call is worthless but the put is ITM (the loss is determined by the value of the put minus the initial credit received).
Max Loss = Unlimited
Suppose stock ABC is trading at $40 in January. An options trader is neutral on ABC decides to enter a straddle position by selling an ATM $40 call and ATM $40 put. Both options have a DTE of 45. The trade results in a credit of $275.
The price of ABC stock over the period of the trade ends up at $39. The call is worthless and the put has intrinsic value of $100. The trade results in a $175 profit. If the price settled at $40 exactly, both options would have had $0 intrinsic value and the trade would of resulted in a $275 profit (max profit) minus commissions.
If the stock had rallied to $50 at the end of expiration, the trade would have resulted in a loss of $725. The call has intrinsic value of $1000 and the trader only received a $275 credit. The same thing happens if the stock fell to $30. Except in this scenario, the put has an intrinsic value of $1000. Remember that with short straddles comes unlimited risk, therefore there is no max loss.
When to use a straddle strategy?
At Tradezy, we recommend to use this strategy for stocks with a high implied volatility. The trader should have a short to intermediate neutral thesis. Since the trade has undefined risk, we don’t necessarily have a target amount of premium we want to collect. The large the credit received though allows are breakeven points to expand. The credit received is not only determined by IV, but the price of the underlying asset as well (higher the strike prices = higher the credit) In terms of duration, we look to sell a position that has around 45 DTE. The goal is to buy back the spreads at 25% of max profit.