Let me make this clear from the start. When it comes to Long Straddles and Short Straddles, we are looking at two completely different options strategies. Period!
The similarities of the name do not refer to the direction of the strategy. In fact, “Long” does not indicate a bullish trade and “Short” does not indicate a bearish trade. Instead, what that means is that in a Long Straddle you are purchasing the strategy, while in a Short Straddle you are selling the strategy. In the first case you are an options buyer, in the second case you are merely an options seller.
In this article, I am going to analyze the risk graph of a Long Straddle I traded on the Boeing Company (BA) on the 3rd of July 2023 and the risk graph of a Short Straddle I made on Home Depot Inc. (HD) on the 24th of May 2023. If you look at the strategies graphically, both have a V-shaped risk profile, but with a totally opposite orientation. In other words, the risk graph of a Short Straddle appears like an upside-down Long Straddle. You can see the risk profiles of both strategies in the video below.
Long Straddles are known as a debit strategy. Basically, with this option strategy you are purchasing options premium and you are merely an option buyer. As you purchase ATM call and put options with the same strike price, a Long Straddle is regarded as an expensive strategy. The maximum potential loss is limited to the entry debit or max investment and can be experienced if the underlying is trading exactly at the strike price at expiration.
Long Straddles Mechanics and Greeks
A Long Straddle is a Delta neutral strategy as the direction of the underlying does not matter. You are looking for a sudden explosive move of the underlying security either upwards or downwards and in a reasonable amount of time to make the trade profitable. It has great potential because with a substantial directional move of the stock you can achieve unlimited profit.
A Long Straddle is Vega positive because the strategy gets advantage of an increase in implied volatility. To improve your chances of success you want to purchase options with low implied volatility which is due to increase following the price action of the underlying and specific market news. A Long Straddle is Theta negative because the strategy is negatively affected by the passage of time. As a result, you want to buy ATM options that are far away from expiration (between 120-180 days) and hold them for a short amount of time (30-45 days) not to get affected by time decay.
Short Straddles are a credit strategy as in this case you are an options seller. You sell ATM call and put options with the same strike price. It achieves the maximum profit (equal to the entry credit received at the outset) if the underlying security is trading at the sold strike price at expiration. As you are selling naked options - not baked by any options purchased - this strategy has the huge drawback of having an unlimited potential loss which makes it extremely risky.
To allow to trade this strategy, brokers apply a high margin requirement which can be 3 or 4 times the entry credit received. In most cases, the premium received from the sale of the Straddle may be applied to this initial margin requirement. On top of that, the maintenance margin can further increase if the trade gets into losing territory or decrease if the trade goes into profit. These margin requirements may vary from broker to broker. As a Short Straddle could face a potential unlimited loss if things go wrong, brokers use these high margin requirements to protect themselves. All of this makes the strategy extremely expensive and not cost-effective.
Short Straddles Mechanics and Greeks
A Short Straddle is a Delta neutral strategy as the direction of the market does not matter as long as the underlying security is trading in a range close to the ATM strike prices sold. Opposite from a Long Straddle, you are not looking for a sudden directional move of the stock, but just for the stock to trade in a well-defined pattern.
A Short Straddle is Vega negative because the strategy benefits from a decrease in implied volatility. You are looking for an underlying security trading in a range, but with high implied volatility that is due to decrease. A Short Straddle is Theta positive because the strategy is positively affected by the passage of time. As a result, you want to sell ATM options that are close to expiration and benefit the most from the combined effect of time decay and a reduction in the value of implied volatility.
Long Straddle Vs Short Straddle - Summing it Up
Hope this clarify the Long Straddle Vs Short Straddle debate. We are talking about two completely different strategies. You are either extremely bullish or bearish with a Long Straddle and looking for an increase in implied volatility; or you believe that an underlying security will keep trading in a range going nowhere in a market with high implied volatility which is due to decrease.
Because of the unlimited potential loss and the high margins required by the brokers, I would not recommend trading Short Straddles. Especially if you are not an experienced option trader, this strategy may put you under too much pressure. If your goal is to profit from a sideways market where a given stock is trading in a range, you can go for less risky and more affordable strategies such as Calendar Spreads or Iron Condors.
I’ll see you in the next release of the options trading diary.