Uncovered Straddle/Short Straddle/Sell Straddle : Profit From Range Bound Trading

Introduction to Uncovered Straddle/Short Straddle/Sell Straddle

Uncovered straddle

An uncovered straddle involves shorting an equal number of call option contracts and put option contracts derived from the same underlying security and with the same strike price. A trader that executes this strategy is not covered in a sense that he does not own the underlying security. Hence, the risk to this strategy is high as the maximum loss is unlimited. The uncovered straddle is also known as a “short straddle” and “sell straddle”. The other issue with this strategy in our opinion is that the maximum profit can be attained at only one price point.

Net Credit

The execution of this trade will result in a net credit.

Read more : What does “net credit” mean in options trading?

Margin requirements

Margin requirements will be stringent for this trade as it is risky. Consult your preferred broker regarding this trade.

Read more : Understand The Fundamentals Of Margin requirements

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Low Volatility & Range Bound Trading
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Unlimited potential loss
Step 7 : Calculation of losses
Step 8 : Limited profit
Step 9 : Calculation of profit
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade – Executing a short straddle/uncovered straddle/sell straddle strategy
Step 12 : Exiting a short straddle/sell straddle/uncovered straddle
Step 13 : Record Trade In Diary

Step 1 : Perform economic, fundamental and technical analysis

The options trader must perform economic, fundamental and technical analysis to assess the outlook on the markets and the underlying security. For a short straddle, some of the chart patterns the options trader should look out for are:

Read : Basic Economic Analysis, Basic fundamental Analysis and  Introduction to technical analysis

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Step 2 : Outlook – Low Volatility & Range Bound Trading

The trader that executes this strategy has the view that the underlying security will trade within a narrow range. When that happens, the trader stands a chance of realising a maximum profit.

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Step 3 :Study the option chain

Examine the options chain. Select the options to be used in the short straddle. Select the options which are at the money. In reality, due to movement in prices, you may not be able to find at the money options. However, you can select options whose strike prices are closest to the  stock price.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

The breakeven price points occurs occurs at 2 different values because of the nature of this trade, that is, the trade is uncovered.

The upside breakeven point can be calculated as:

Exercise or strike price of call + total premiums collected

The downside breakeven point can be calculated as:

Exercise or strike price of put – total premiums collected

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Step 5: Understand Your Profit Zones

Uncovered straddle

After the breakeven points have been calculated, the trader can determine the profit zone. The profit zone for a short straddle is between the breakeven points.

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Step 6 : Unlimited potential loss

The short straddle has an unlimited loss potential. Potentially, the trader that executes a short straddle can lose a lot of money.

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Step 7 : Calculation of losses

When the price of the underlying security is > the sum of the premiums collected from the writing of the options and the strike(exercise) price of the written call, the loss can be calculated as:

Price of the underlying security -(Strike price of written call + total collected premiums from writing options) + commissions paid to broker

When the price of the underlying security is <  than the difference of the premiums collected from the writing of the options and the strike price of the written put, the loss can be calculated as:

Strike price of written put – (price of underlying security + total premiums collected) + brokerage commissions paid to broker

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Step 8 : Limited profit

The maximum profit of the short straddle or uncovered straddle is the total amount of premium collected when the options are shorted. Another point to note is that the maximum profit occurs when the price of the underlying security is equal to the strike(exercise) prices of the options.

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Step 9 : Calculation of profit

Maximum profit = Total collected premiums less commissions paid to the broker

Potential for unlimited losses

As the price of the underlying security  goes up indefinitely, the potential for losses is theoretically unlimited. If the price of the underlying security goes to zero, the loss is equivalent to the strike price of the options. The loss occurs when:

  • The price of the underlying security is greater than upside breakeven point
  • The price of the underlying security is less than the downside breakeven point

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Step 10 : Calculate Risk & Reward Ratio

Assuming that stop losses are in place and potential exit prices are identified, the trader is able to calculate the estimated risk and reward ratio. By calculating the risk and reward ratio(even if it is estimated), a trader is able to compare the attractiveness of one trade relative to another on a risk and reward basis.

Read : Understanding Risk/Reward Ratio For Option Traders

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Step 11 : Set Up Trade – Executing a short straddle/uncovered straddle/sell straddle strategy

The short straddle involves writing 1 ATM put and 1 ATM call with both options having the same strike price and expiration date. The ratio of written puts to written calls is 1:1.

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Step 12 : Exiting a short straddle/sell straddle/uncovered straddle

  1. If the price of the underlying security falls below the lower or downside breakeven point, the options trader can close out the put position for a loss to prevent assignment.
  2. If the price of the underlying security trades between the upside and downside breakeven points, the trade is profitable. The maximum profit occurs at the strike price of the options involved. At the strike price, the options will expire worthless and the option trader gets to keep the credit received from writing the options.
  3. If the price of the underlying security increases to a price point above the upside breakeven point, the trader should consider closing out the call for a loss to prevent assignment from occurring.

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Step 13 : Record Trade In Diary

After the trade has been exited, record the trade in a diary. Detail the trade’s performance and perform reflection and analysis on the trade to become a better trader.

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Example of an uncovered straddle(short straddle)

ABC company trades at $30 per share. A trader writes a July 30 put and a July 30 call. The July 30 call is worth $2 and the July 30 put is worth $2. In total the trader collects a premium of $200 + $200 = $400 . $400 is the maximum possible profit from the trade.

If the trading price of ABC company is $30 when the options expire, both options expire worthless and the trader’s profit is $400.

The upside breakeven price point is:

$30 + $2  = $32

The downside breakeven price point is:

$30 – $2 = $28

As long as the stock trades within the price range of $28 and $32, the trader can realise a profit when he closes his positions. Beyond that range, the trade will experience a loss when he closes his position.

If the price of the company trades at $40 on expiry, the trader will make a loss as the price is above the upper breakeven price point.

Let us consider the scenario where the stock trades at $35. When that happens the ending value of the call will be $500. The options position will be closed out at a loss of : $500 – $200 = $300

The total loss to the trade will be : $300 – $200 (premium from put option which expired worthless) = $100

If the price of the company trades at $25, the loss on the put position is $500 – $200 = $300 when it is closed out. The call option expires worthless and gets to keep $200 of premium. The total loss to the trade then would be $300 – $200 = $100

Long straddle

The long straddle involves going long on an equal number of call option contracts and put options contracts at the same strike price derived from the same underlying security. Compared to a short straddle or uncovered straddle, the profit is unlimited.

Th uncovered straddle/short straddle/ sell straddle versus Long straddle

The long straddle is a strategy that is opposite to  the uncovered straddle.

Read : Option straddle(Long straddle)

Read also : Execute A Calendar straddle : Profit from low volatility

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