The Risks with Short Straddles

Looking at an at-expiration diagram or even analyzing the gamma/theta relationship of a short straddle may sometimes lead to a false sense of comfort. Sometimes it looks as if short straddles need a pretty big move to lose a lot of money. So why are they definitely among the riskiest strategies to trade? Option trading is about risk management. Dealing with a proverbial train wreck every once in a while is part of the game.

But the big disasters can end one’s trading career in an instant. Because of its potential—albeit sometimes small potential—for a colossal blowup, the short straddle is,indeed, one of the riskiest positions one can trade. That said, it has a place in the arsenal of option strategies for speculative traders.Trading the Short Straddle:A short straddle is a trade for highly speculative traders who think a security will trade within a defined range and that implied volatility is too high.

While a long straddle needs to be actively traded, a short straddle needs to be actively monitored to guard against negative gamma. As adverse deltas get bigger because of stock price movement, traders have to be on alert, ready to neutralize directional risk by offsetting the delta with stock or by legging out of the options. To be sure, with a short straddle, every stock trade locks in a loss with the intent of stemming future losses.

The ideal situation is that the straddle is held until expiration and expires with the underlying right at $70 with no negative-gamma scalping. Short-straddle traders must take a longer-term view of their positions than long-straddle traders. Often with short straddles, it is ultimately time that provides the payout.

While long straddle traders would be inclined to watch gamma and theta very closely to see how much movement is required to cover each day’s erosion, short straddlers are more inclined to focus on the at-expiration diagram so as not to lose sight of the end game.There are some situations that are exceptions to this long-term focus.For example, when implied volatility gets to be extremely high for a particular option class relative to both the underlying stock’s volatility and the historical implied volatility, one may want to sell a straddle to profit from a fall in IV.

This can lead to leveraged short-term profits if implied volatility does, indeed, decline.Because of the fact that there are two short options involved, these straddles administer a concentrated dose of negative vega. For those willing to bet big on a decline in implied volatility, a short straddle is an eager croupier. These trades are delta neutral and double the vega of a single-leg trade. But they’re double the gamma, too.

As with the long straddle, realized and implied volatility levels are both important to watch.Short-Straddle Example:For this example, a trader, John, has been watching Federal XYZ Corp.(XYZ) for a year. During the 12 months that John has followed XYZ, its front-month implied volatility has typically traded at around 20 percent,and its realized volatility has fluctuated between 15 and 20 percent.

The past 30 days, however, have been a bit more volatile. Exhibit 15.6 shows XYZ’s recent volatility.The stock volatility has begun to ease, trading now at a 22 volatility compared with the 30-day high of 26, but still not down to the usual 15-to-20 range. The stock, in this scenario, has traded in a channel. It currently lies in the lower half of its recent range.

Although the current front-month implied volatility is in the lower half of its 30-day range, it’s historically high compared with the 20 percent level that John has been used to seeing, and it’s still four points above the realized volatility. John believes that the conditions that led to the recent surge in volatility are no longer present. His forecast is for the stock volatility to continue to ease and for implied volatility to continue its downtrend as well and revert to its long-term mean over the next week or two.

John sells 10 September 105 straddles at 5.40. Exhibit 15.7 shows the greeks for this trade.The goal here is for implied volatility to fall to around 20. If it does,John makes $1,254 (6 vol points 3 2.09 vega). He also thinks theta gains will outpace gamma losses. The following is a two-week examination of one possible outcome for John’s trade.Monday following his entry into the trade, the stock rose to $106.

While John collected a weekend’s worth of time decay, the $1.25 jump in stock price ate into some of those profits and naturally made him uneasy about the future.At this point, John was sitting on a profit, but his position delta began to grow negative, to around 21.22 [(1.18 3 1.25) 1 0.26]. For a $104.75 stock, a move of $1.25—or just over 1 percent—is not out of the ordinary, but it put John on his guard. He decided to wait and see what happened before hedging.