Trading the Short Straddle
A short straddle is a trade for highly speculative traders who think a security
will trade within a defined range and that implied volatility is too high.
While a long straddle needs to be actively traded, a short straddle needs to
be actively monitored to guard against negative gamma. As adverse deltas
get bigger because of stock price movement, traders have to be on alert,
ready to neutralize directional risk by offsetting the delta with stock or by
legging out of the options. To be sure, with a short straddle, every stock
trade locks in a loss with the intent of stemming future losses. The ideal
situation is that the straddle is held until expiration and expires with the
underlying right at $70 with no negative-gamma scalping.
Short-straddle traders must take a longer-term view of their positions than
long-straddle traders. Often with short straddles, it is ultimately time that
provides the payout. While long straddle traders would be inclined to watch
gamma and theta very closely to see how much movement is required to
cover each day’s erosion, short straddlers are more inclined to focus on the
at-expiration diagram so as not to lose sight of the end game.
There are some situations that are exceptions to this long-term focus. For
example, when implied volatility gets to be extremely high for a particular
option class relative to both the underlying stock’s volatility and the
historical implied volatility, one may want to sell a straddle to profit from a
fall in IV. This can lead to leveraged short-term profits if implied volatility
does, indeed, decline.
Because of the fact that there are two short options involved, these
straddles administer a concentrated dose of negative vega. For those willing
to bet big on a decline in implied volatility, a short straddle is an eager
croupier. These trades are delta neutral and double the vega of a single-leg
trade. But they’re double the gamma, too. As with the long straddle,
realized and implied volatility levels are both important to watch.