sinking feeling in the pit of your stomach. But the damage was truly not that
bad. The offer in the straddle was 4.75, so the position was still a winner if
John bought it back at this point.
Gamma/delta hurt. Theta helped. A characteristic that enters into this
trade is volatility’s changing as a result of movement in the stock price.
Despite the fact that the stock gapped $3.50 higher, implied volatility fell by
1 percent, to 22. This volatility reaction to the underlying’s rise in price is
very common in many equity and index options. John decided to close the
trade. Nobody ever went broke taking a profit.
The trade in this example was profitable. Of course, this will not always
be the case. Sometimes short straddles will be losers—sometimes big ones.
Big moves and rising implied volatility can be perilous to short straddles
and their writers. If the XYZ stock in the previous example had gapped up
to $115—which is not an unreasonable possibility—John’s trade would
have been ugly.