6 Ways to Reduce Short Straddle Risks

12/09/2013 8:00 am EST

Focus: OPTIONS

Michael Thomsett

Founder, Thomsett Publishing Website

Even though the short straddle has a reputation for being an extremely risky strategy, the risks are not as bad if you know what you’re doing, says option expert Michael Thomsett of ThomsettOptions.com.

The short straddle is dangerous because, well for one thing, both sides are short. Making things even riskier, one side or the other is always in the money.

Even so, the true risk of the short straddle might not be as severe as traders often assume. Consider how much risk is reduced in the following circumstances:

1. Premium is very rich. The best short straddles (a short straddle is selling a call and put on the same underlying, same strike and same expiration) are those that, given the at-the-money or near-the-money conditions, offer overall very rich premium.

2. Expiration takes place in one month or less. Try to limit short straddles to very short-term options, because time decay will be rapid in the final month.

3. Keep an eye on the strike versus current price. Plan to close positions as soon as possible, especially those moving in the money. A slight move often is offset by declining time value, so even unfavorable moves can be countered with a profitable close. You can also roll out to a later expiration to avoid exercise.

4. You plan to close both sides once time decay starts to hit. Or, if intrinsic value moves too quickly, you plan to roll forward (up in strike with the short call or roll down with the short put) and duplicate the strategy. The forward roll might become inevitable for one side depending on direction of price movement. Ideally, the stock price will not change much, so time decay could make both sides work profitably.

5. You also can cover the short call or put if circumstances make it necessary. You can cover with stock or long options, although that’s an expensive proposition. The attractive shorts usually have a correspondingly expensive long, so covering with long options is not the best way out of the straddle.

6. You are willing to get exercised as long as it nets out to a profit for you. Exercise can be a good thing. As long as the market value is within the profitable point range above or below the strike, exercise is still profitable.

Even though these numbers look like the idea can work out, remember the one rule about short combinations: Even when they work on paper and even when they should work in practice, they can also go wrong, expensively and quickly. If you’re going to do short straddles, keep them within sight of expiration and be willing to accept the risks. Also make sure you have the equity to meet margin requirements, which are equal to 100% of strike value. One last item: Since this position includes two short option positions, make sure you are approved for this type of trade before trying to place it.

By Michael Thomsett of ThomsettOptions.com

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