It is the opposite of the long straddle strategy. It consists of the simultaneous writing of the same number of ATM calls and puts, with the same expiration and strike price, on the same underline security.
When to use
When we believe that the price of the underline security will remain stable and the implied volatility is also high. The higher the implied volatility the more money we earn from the short selling of the premiums and if the stock at expiration is exactly ATM we will accomplish the maximum profit. If the stock moves in either direction we don’t want the movement to exceed the aggregate per share premium because in that case we are starting to lose money.
Suppose we have written one ATM call with premium $2 and one ATM put with premium $1 and strikes $25. The aggregate premium received per share is $3. If the underline security moves $3 in either direction then we are break-even (without estimating commissions), because the loss from the short positions in options will be counter-weighted from the premium received. A movement of the stock above $3 in either direction will start producing losses.
The short straddle is a very dangerous strategy because it has almost unlimited potential losses. It must be applied for very short term periods because stock prices rarely remain unchanged for a long time.
Loss/Profit at expiration
Maximum loss: Unlimited to the upside and until the stock falls to zero to the downside + commissions.
Maximum profit: Premiums received – commissions.
Below we can see the profit/loss diagram for the short straddle strategy. We are long one call with premium $2 and one put with premium $1 and strikes $25.
Short straddle strategy example
In the daily chart of stock C (below) price has visited a not very strong resistance (line 1) and we believe that after some consolidation it will make a breakout, maybe in less than a week. The market (SPY) is in a mild uptrend. We can write one ATM call with premium $0.60 and one ATM put with premium $0.30, when the stock price is at point A, which both expire after 1 week. The fact that they are very close to expiration augments the effect of time decay on premiums and every day the options will lose a certain amount according to their Theta. If the implied volatility was also high when we sold the options, then a potential deflation will lessen the value of the premiums even more. If the stock at expiration has moved in either direction $0.90, then we are break-even (without estimating commissions). Above that amount we are losing money.
Due to the inherited risk of the strategy the position should be closed as soon as we have a decent percentage profit, without anywise waiting until expiration. If the stock moves aggressively against us we must be alert to immediately close the position to avoid big losses.