What is a short straddle?
A short straddle is when you sell a call option and a put option at the same time with the same expiration date and the same strike price. Short straddles are usually sold at-the-money of the underlying asset. However, you can also open a short straddle above or below the stock price to express a bullish or bearish bias in your trade.
The strategy profits from a drop in volatility, time decay, and little or no movement from the underlying asset. Short straddles have undefined-risk and limited profit potential.
When to use a short straddle strategy
Some traders might use a short straddle strategy when they think that implied volatility is too high and expect a decline. Whenever implied volatility is high, the prices for call and put options might become equivalently elevated.
Short straddles become profitable during periods of little to declining implied volatility, which generally translates into very little movement in the underlying stock. So after entering a short straddle, the idea is to wait for volatility to drop before closing the position at a profit.
Short straddles are market neutral and do not favor any direction in the underlying.
How to manage a short straddle position
Time decay is helpful when you want to profit from a short straddle. Assuming implied volatility stays the same or falls, over time the price of both options you sold will decline. That means if you choose to close your position before expiration, it will be cheaper to buy back.
When you enter a short straddle, you want implied volatility to decrease. An increase in implied volatility can be dangerous because it makes the price of both options you sold go up.
Short straddle maximum profit potential
The potential profit from a short straddle is limited to the amount of money you make when selling the call and the put.
Short straddle maximum loss potential
If the stock price goes up, you could in theory lose an unlimited amount of money. If it falls, your losses may also be significant, but they will be buffered by the credit you received from selling the straddle.