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.
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.
Smart Investor TipFor each and every strategy with limited profit potential, always ask the critical question: is it worth the risk?
[caption id="attachment_12582" align="aligncenter" width="300"] 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
|Price||July 40 Call||July 40 Put||Total|
|46||- 300||+ 100||- 200|
|45||- 200||+ 100||- 100|
|44||- 100||+ 100||0|
|43||0||+ 100||+ 100|
|42||+ 100||+ 100||+ 200|
|41||+ 200||+ 100||+ 300|
|40||+ 300||+ 100||+ 400|
|39||+ 300||0||+ 300|
|38||+ 300||- 100||+ 200|
|37||+ 300||- 200||+ 100|
|36||+ 300||- 300||0|
|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.[/caption]