SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Selling Straddles: Too Risky?


A question from a reader: "I sell straddles, usually 30-45 days prior to expiration on the SPX index at the current market price. What do you think is the best option strategy to offset large moves up/ down? Would buying a straight put (or a put spread) be best? It's an expensive route to take and just wondering if you have another solution?"

The truth is that selling straddles is a strategy that seeks a high profit and it must come with significant risk. 

 

When you are naked short options, loss is theoretically unlimited – and there's nothing to be done about that.  Sure, we know there will not be a 50% one-day rally, nor will there be a one-day 75% decline.  But they are theoretically possible and that makes it impossible to estimate the maximum loss for the straddle. 

 

If willing to live with the risk of a gigantic loss, then you may be comfortable selling straddles. However, because you are asking about risk reduction, I assume that unlimited loss is something you prefer to avoid.

 

Iron Condor vs. Straddle

 

The best (in my opinion) protection is to buy a put that is farther OTM than your short put.  In other words, I am willing to pay that very high price for the put because it provides complete protection against a huge gap opening – or any significant move.  By 'complete protection' I mean it establishes a maximum possible loss.  When you have the ability to set that loss potential, you are in position to trade more effectively.

 

Money management

 

For example, when you recognize the worst possible result, you are better able to size the trade properly.  Translation:  You can make a very good judgement about how many contracts to trade.  When selling straddles, there is no good method to allow effective money management. 

 

Note the difference: You can manage risk by adjusting positions as needed – assuming that there is no large market gap.  However, there is no way to practice sound money management money when you don't have a good  estimate of how much is at risk.

 

Yes, this is very expensive, reduces potential profits significantly and converts the straddle into an iron condor (assuming you do this on both the put and call sides).  However, it does allow you to have a better handle on money management and risk management.

 

Alternative: Strangle

 

If you fear, or anticipate a market decline, you can take out partial insurance right now – when initiating the position.  There is nothing magical about selling straddles, and you can trade a strangle instead.  In this scenario, you would sell the 1185 call, as planned, but could choose a lower strike put.  Perhaps the 1165 or the 1150 put?  The point is that you build in your market bias by making a small (not 100 points) adjustment in the strike prices of the options sold.

 

risk.jpg

 

Protection

 

I've been trading options since 1975 and have come to one major risk management rule that suits my comfort zone.  I no longer sell any naked options (unless I want to buy stock and elect to sell a naked put in an attempt to buy stock at a lower price).  I have incurred too many large losses from being short far too many naked options – both calls and puts.  I am NOT telling you to adopt that same limitation.  What I am doing is asking you to consider the risk of selling straddles and decide if it works for you.  It may be a perfect (high risk) strategy for your trading style.

 

a) Buying debit spreads (puts in your example) is far less costly and provides far less protection than buying single options.  And that protection is limited. But if there is no huge gap, this is a very useful method to reduce risk. 

 

I'd prefer not to constantly use the phrase 'if there is no gap,' but the truth is, that's the big, ugly enemy for the naked call or put seller.  That gap eliminates the opportunity to make a timely adjustment before disaster occurs.

 

b) Another risk management method to consider is to reduce the time that you own the short straddle position.  True, the most rapid time decay comes near expiration, but if you take the extra risk associated with selling naked options, you can counter some of that risk by not holding into expiration.  Consider owning the position for only two or three weeks, taking the profit, and waiting patiently until it's time to open a new straddle.  Being out of the market is one sure method for reducing risk.

 

c) Other solutions exist, but buying single options or debit spreads represent the most simple and effective choices.

 

Another example is an OTM put backspread.  But please be warned:  The risk graph may look very good today and you may feel adequately protected today, but the passage of time turns these into situations in which you may incur a big loss from the original straddle plus another from the back spread.

 

Example

 

Buy some SPX Dec 1120 puts and sell fewer SPX Dec 1130 puts.  Because you own extra options, the gigantic downside move will not hurt.  However, if SPX declines and moves near 1120 as expiration arrives, this backspread can lose big money.

 

This is not the appropriate time to go into a further description of the backspread, but some of the problems are mentioned in this post.

 

Related articles

 

Want to learn how to trade options in a less risky way?

 

Start Your Free Trial

 

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Probability and Option Risk

    A lot is said about probability of profitable outcomes in option trades, but do we truly understand what probability is or how it works? Options traders can become better informed and even wiser by looking a step beyond the well-known conclusions.

    By Michael C. Thomsett,

    • 0 comments
    • 250 views
  • Using ORATS in Anchor Testing

    The purpose of the below piece is to demonstrate how Lorntine Capital uses ORATS (Options Research and Technology Services) in our own backtesting. Note: ORATS does not pay me for writing this but has requested that if we like the software, we assist in promoting it.

    By cwelsh,

    • 1 comment
    • 350 views
  • Calculating the Probability of Option Payoff

    A calculation of “breakeven” as well as maximum profit or loss, sets up a single system for modeling and comparing one option to another. But it might also require traders to adopt an unrealistic assumption about outcomes based on best-case or worst-care scenario.

    By Michael C. Thomsett,

    • 0 comments
    • 382 views
  • Realistic Expectations: Using History as A Guide

    One of the biggest challenges I come across with the typical investor is maintaining realistic expectations and being able to properly understand the tradeoffs between risk and return. We all want high returns with low risk and there’s no limit to the efforts we’ll make to find it.

    By Jesse,

    • 0 comments
    • 410 views
  • CAPM As an Alternative Option Pricing Model

    Options traders endlessly debate the merits of the Black-Scholes pricing model. Some swear by it and others don’t even try to use it. Given the many profound flaws in the model, it is not an accurate tool for developing a sense of where price is likely to move in the future. But there are alternatives.

    By Michael C. Thomsett,

    • 0 comments
    • 581 views
  • Option Payoff Probability

    Options traders must, naturally, be concerned with the likelihood of payoff for a strategy. Ironically, one of the most often cited statistics about profit and loss is simply incorrect. That statistic is captured in the headline of a story posted online “Trading Options: Data Shows That 75% or More of Options Expire Worthless.”

    By Michael C. Thomsett,

    • 0 comments
    • 675 views
  • The Minimum Effective Dose (MED) For Cash Flow Planning

    Financial planners can usually give generic advice that will be appropriate for the majority of Americans, and that’s the goal of this article. If we can get the fundamentals of cash-flow planning right (where to put your money after you earn it and pay your taxes and bills), we’re 80% of the way towards maximizing our financial situation.

    By Jesse,

    • 0 comments
    • 672 views
  • Are You Breaking Even? Or Losing?

    Among the good reasons to trade options is the need to meet or surpass your breakeven yield. This is the yield you need just to preserve your purchasing power; and it higher than most people think. In fact, most people relying on moderate to conservative yields from stocks, mutual funds, real estate and savings accounts might be earning well below this breakeven level.

    By Michael C. Thomsett,

    • 0 comments
    • 772 views
  • Buy When You Have the Money, Sell When You Need the Money

    Money can be quite an emotional topic for many of us. Emotions can enhance our experiences and relationships in many ways, but they can act as mental roadblocks especially when trying to make wise financial decisions. One of the most common emotional roadblocks I come across when working with individuals is an unwillingness to invest idle cash to meet long-term goals.

    By Jesse,

    • 0 comments
    • 1,561 views
  • Strategy Selection vs. Risk Management

    "A billion here, a billion there, and pretty soon you're talking about real money." Everett McKinley Dirksen. Let’s begin with the bottom line: When I talk to anyone about the concept of choosing an option strategy (or two) to adopt for trading, I stress that the strategy should have certain characteristics.

    By Mark Wolfinger,

    • 0 comments
    • 743 views

  Report Article

We want to hear from you!


There are no comments to display.



Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs