Wednesday, 8th September 2010

Writing Straddles

Written by George Traganidas Topics: Articles, Options, Wealth Building

Fool.com
By Jeff Fischer
November 18, 2009

Why write a straddle?

  • You believe a stock or index is going to hold steady or stay in a tight range.
  • You believe a stock that was recently volatile will settle down considerably.
  • You believe the market’s overall volatility is going to decrease.

Setting Up the Trade

A straddle uses an identical number of calls and puts with the same strike price and expiration date on the same underlying stock or index. As you know from our Buying Straddles lesson in Options U., you buy identical calls and puts on a stock to profit in either direction from volatility, but you need a sharp and lasting move in either direction in order to profit overall. Inversely, writing the calls and puts is a way to profit from low or declining volatility. How? Simply by collecting option premium payments on either side of a potentially sleepy position. There are risks, of course, but let’s start with the basics:

  • Write (“sell to open”) an equal number of puts and calls on the same stock or index.
  • Use the same strike price and the same month of expiration on both options.
  • The strike price with a straddle is “at-the-money” — as close to the current underlying stock or index price as possible.
  • When you write an uncovered straddle, you don’t own the underlying stock, so your risk is high (more on this in a minute).
  • When you write a covered straddle, you own the stock, lowering your risk on one side of the option trade. Here the straddle works like a covered call strategy — but your returns are potentially goosed with additional put-writing income, and you need to be ready to buy more shares of the stock if it falls, just like when you write any puts.

The most you can earn from the options when writing straddles is what the options pay you initially.

Uncovered Straddle Writing

When writing an uncovered straddle, you usually don’t intend to get the underlying stock involved. You’re just looking to profit on the value erosion of the options you write, and you’ll plan to “buy to close” them (or let them expire) once you’ve earned your targeted profit. (Note: You need a margin account to write an uncovered straddle.)

As an example, suppose a recently volatile stock just announced earnings, and you expect its volatility will now all but cease. The options still pay well, though, so you’d like to capture the option premium as income. The stock is trading at $25, so you write $25 calls and $25 puts and get paid $2 for each contract — that’s $4 total in option premiums per straddle you set up. This means as long as the stock ends the expiration period between $21 and $29 ($4 above or below $25), you’ll at least break even before commissions — and if the stock is between these prices, you earn a profit on the trade. (We’ll call this the “profit range.”)

  • For example, if the stock ends the period at $27, the puts you wrote expire (giving you the full $2 value), and the calls break even, so the trade pays you $2 per share overall.
  • If the stock ends lower in our profit range — let’s say $23 — the calls expire and the puts break even, so your profit is $2 per share overall here, too.

However, outside your profit range, it’s another story. With uncovered straddles, you face unlimited potential losses as the stock rises above $29 per share, and you facing growing losses (along with an obligation to buy the stock and wait for a recovery) the further it falls below $21.

As the table below shows, the maximum profit from an uncovered straddle occurs when the stock ends exactly at the strike price; you essentially keep the entire $4 per share you were paid in this example. Your total profit declines as the stock moves away from the strike price in either direction — which is why you want minimal volatility whenever you write straddles.

Take a minute to study the table to grasp how this works. As the stock rises, the naked (or uncovered) calls you wrote increase in value, working against you. As the stock declines, the puts you wrote work against you, but you’ll still profit anywhere between $22 and $28, and break even at $21 or $29. Remember, you were paid $2 for each call and put, or $4 total. But since you wrote the options, your desired outcome is that their value goes to $0, or as low as possible:

Ending Call Value Stock Price at Expiration Ending Put Value Your Total Profit per Share
$0 $20 and lower $5 and higher as the stock falls ($1) and worsening as the stock falls
$0 $21 $4 Break-even
$0 $22 $3 $1
$0 $23 $2 $2
$0 $24 $1 $3
$0 $25 (the strike price) $0 $4
$1 $26 $0 $3
$2 $27 $0 $2
$3 $28 $0 $1
$4 $29 $0 Break-even
$5 and higher as the stock rises $30 and up $0 ($1) and worsening as the stock rises

To help achieve a successful uncovered straddle, you want the widest possible profit range (in other words, you want to capture generous option premiums). In our example, the range is significant — $4 in either direction — assuming the underlying stock isn’t exceptionally volatile and your options expire in two to five months (rather than longer). But remember, the trade creates unlimited potential losses outside the profit range.

One way to greatly mitigate that risk: When you write your straddle, use some of your option proceeds to simultaneously buy far out-of-the-money calls and/or puts, too — with strike prices at the two ends of your profit range (for this example, you might buy $30 calls and $20 puts; or just buy calls to protect you on that side and be ready to buy the stock via your written puts if it falls). Doing so, you’ve hedged and “covered” your written straddle, and because buying these options generally costs little, you’ll still begin with a net credit from your option writing and keep that profit if the stock stays in a now slightly tighter range. For example, if you paid $0.80 total for the protective calls and puts, your profit range decreases by that amount on either side of the strike price. If you don’t buy protective options initially, be ready to do so if the trade starts to work strongly against you.

Given that a steady stock can suddenly make a big move for any number of reasons, it’s risky to write uncovered straddles without this added protection. However, another route is to simply own the underlying stock outright. Let’s take a look.

Covered Straddle Writing

Owning the underlying stock takes away all of the naked call option risk when writing a straddle. In fact, a covered straddle-writing strategy is basically a covered call strategy combined with put writing. The key difference with a straddle (as opposed to your typical call or put writing) is that both options start at-the-money, so you’re more likely to see your options exercised if you don’t close them. As with a covered call, it’s important that you’re ready to sell your stock if it rises. And as with writing puts, you need to be ready to buy more stock if it declines (or close the options early). The benefits of writing a covered straddle are two-fold:

1. Your profit can be higher and your profit range wider than with a mere covered call.
2. You have more ways to close your options profitably — and still keep your stock if you like.

Continuing our earlier example, let’s assume you want to write a straddle on a steady $25 stock — but in this case, you own the underlying shares. You write $25 calls and puts, getting paid $2 each, with the same expiration date. Since you own the stock, no matter how high it climbs, you’re covered on that side of your trade. Let’s consider some potential outcomes:

  • You end up selling your stock via the covered calls, but you keep the $4 option premium you were paid on the puts and calls, netting a sell price of $29 (compared with just $27 if you’d only done a covered call and not a straddle).
  • The stock declines below $25. You end up buying more shares, but at a net $21 given the total option premiums you were paid. You’ve added to your existing stock holding at a lower price.
  • The stocks holds steady, around $24 to $26. You can “buy to close” both the calls and puts by expiration and capture much of the profit while keeping your existing shares. Nice!

Finally, as an example of the added flexibility here: Assume the stock increases to $28 by expiration, and you decide you want to keep your shares. Since you were paid $4 per share in option income, you could close your calls for $3, let your puts expire, still have a $1 per share profit on your straddle, and keep your stock. If you had only written covered calls and not a straddle, you’d need to book a loss on your calls if you wanted to keep your stock.

Taking Follow-Up Action

Writing uncovered straddles requires keeping a close tab on your trade. If the stock is moving sharply against you in either direction, you may want take action to limit your losses. One way to do so is to close the losing side of your straddle when the stock reaches your break-even price. In our example, if the stock rises to $29, you might close your call options for a loss and let your puts go, presumably to expiration, keeping your overall losses marginal. If the stock falls, just be ready to buy it via your puts. Uncovered straddles don’t usually lend themselves to rolling forward (to a later expiration date), rolling up (to higher strike prices), or rolling down (to lower strike prices), so you can’t depend on these defensive follow-up moves being readily available to you. As mentioned above, if you defensively buy out-of-the money protective calls (and puts, if you like) when you set up your straddle, your potential profit on the straddle is lower, but you won’t need to actively consider follow-up action.

Writing covered straddles is much less risky and requires less upkeep, but you still want to keep a watchful eye on your strategy, since only your calls are truly covered. You need to be ready to accept more shares if the stock falls below your puts’ strike price. For this reason, some investors will use a lower strike price on the puts they write, providing more leeway — but once you start to stagger strike prices on your calls and puts, you’re not using a straddle anymore, you’re using a strangle — and that’s next in our series!

Bottom Line on Writing Straddles

In Motley Fool Options, we’re not likely to write uncovered straddles without using some protective options as well. Writing covered straddles, however, is a sensible way to increase option profits on a covered call strategy with a tame stock as long as you’re also willing to buy more shares if need be. With this strategy, you have another tool to profit no matter what the market throws your way — in this case, even if the market goes nowhere.

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