Middle Profit Zones

In the previous example, two related long positions were opened, creating a middle loss zone on either side of the striking price. The opposite situation -- a middle profit zone -- is created through opening a short straddle. This involves selling an identical number of calls and puts on the same underlying stock, with the same striking price and expiration date. If the stock's market price moves beyond the middle profit zone in either direction, this position would result in a loss. Short straddles offer the potential for profits when stocks do not move in an overly broad trading range, and when time value premium is higher than average.

Less volatile stocks also tend to contain lower time value, whereas more volatile stocks have higher time value and higher risks with short straddles. Because time value decreases as expiration approaches, the advantage in this position is the same as for sellers of calls and puts individually -- time works for the short seller.


Example

Straddling with Anticipation: You open a short straddle. You sell one March 50 call for 2 and one March 50 put for 1; total proceeds are $300. As long as the underlying stock's market value remains within three points of the striking price -- on either side -- the position will remain profitable. But if a change in current market value of the stock exceeds the three-point range, the short straddle will produce a loss.

The problem with the short straddle is that one side or the other is always at or in the money, so the risk of exercise is constant. The previous example does not allow for the transaction costs. In a practical application, the profit zone would be smaller for single options. The best outcome for this strategy, assuming that exercise does not take place, is that both sides will lose enough time value so that they can both be closed at a profit. Considering that the profit margin will be slim and risks are considerable, you need to evaluate whether this two-sided short position would be worth the risk. As with other examples of advanced strategies, the short straddle is likely to result from opening one position and later adding the other.

Smart Investor Tip

For each and every strategy with limited profit potential, always ask the critical question: is it worth the risk?

An example of a short straddle with defined profit and loss zones is shown in Figure below. In this example, you sell one July 40 call at 3, and one July 40 put at 1; total proceeds are $400. This creates a four-point profit zone on either side of the striking price.

[caption id="attachment_12582" align="aligncenter" width="300"]Short straddle profit and loss zones. Short straddle profit and loss zones.[/caption]

The short straddle in this example creates a middle profit zone extending four points in both directions from striking price. Unless the stock's market value is at the money at the point of expiration, the likelihood of exercise on one side or the other is high. Table below summarizes the outcome of this short straddle at various stock price levels.

Profits/Losses from the Short Straddle Example

PriceJuly 40 CallJuly 40 PutTotal
$47-$400+$100-$300
46- 300+ 100- 200
45- 200+ 100- 100
44- 100+ 1000
430+ 100+ 100
42+ 100+ 100+ 200
41+ 200+ 100+ 300
40+ 300+ 100+ 400
39+ 3000+ 300
38+ 300- 100+ 200
37+ 300- 200+ 100
36+ 300- 3000
35+ 300- 400- 100
34+ 300- 500- 200
33+ 300- 600- 300

Actual profits and losses have to be adjusted to allow for trading costs on both sides of any position. A thin margin of profit can be entirely wiped out by those fees, making more elaborate option strategies less than practical, notably when using only single options. To compare outcomes of long and short straddles, refer to Figure below, which shows profit and loss zones in a side-by-side format for each strategy.

[caption id="attachment_12584" align="aligncenter" width="480"]Comparison of long and short straddle strategies. Comparison of long and short straddle strategies.[/caption]
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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