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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.

 

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