Options Strategies for a Volatile Market (Part 2)

09/24/2008 12:00 am EST

Focus: OPTIONS

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

Short Straddles

Sometimes traders evaluating a straddle feel like the barriers are so far away that there is just no way that this trade could become profitable in the timeframe they have given it. It's a fair objection, and if you feel this way, or can't find stocks or indexes that are likely to move outside the straddle range, you should consider taking the other side of the trade and become the straddle writer by selling the straddle contract.

Using the same example we used in the last section, imagine that you were confident that the market was not going to decline or rise significantly in the long term. You could see that same straddle at the bid prices pays a slightly smaller premium of $7.89 per share or $789 per contract.


Pizz Chart

Now the trade is paying you the option premium up front, and you are forecasting that the market will not move outside a range of $7.89 above and below the 50 strike price. Selling, or writing, the straddle has a distinct advantage of "time decay" over a long straddle.

A short straddle will lose value to the buyer, ("decay") as time passes. If the market continues to oscillate between support and resistance levels, staying inside your straddle range, the straddle will lose value because it has less and less time to move outside the range that will make it profitable to a buyer.

Because the initial options you sold were at the at-the-money strike price, almost all of the total premium is time value, which presents a lot of opportunity for you the trader.

The risk of a short straddle is that if the market moves a lot, the short option that is losing value could accumulate large losses. That is something to consider as you evaluate a short straddle as an opportunity in your own account, and you should have an exit strategy planned if the trade turns against you.

By John Jagerson, of PFXGlobal.com and LearningMarkets.com.

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