Options naked straddles: A more modest approach
For those who have been active in the markets for a quarter-century or more, it’s difficult to find anything unique. But when it comes to options, the list of strategies is enormous. These include such methods as bull put spreads, butterflies, iron condors, bear call spreads, straddles, strangles, etc. Then, there are variations. Here, we’ll look at one variation of the classic straddle called the scantily clad straddle.
The scantily clad straddle is a premium-capturing program that involves selling the straddle and then placing orders in the underlying commodity to provide a level of coverage should the underlying move significantly in one direction.
The scantily clad straddle can be used in any market that has options, including futures, forex, stocks and bonds.
For those new to options, a straddle is a trade that engages both at-the-money put and call options. If the S&P 500 futures are trading at 1,000, then selling the straddle would involve selling the 1,000 put and the 1,000 call. A long straddle would purchase both options. A straddle is usually a volatility play rather than a directional trade, with a long straddle betting on an increase in volatility and a short straddle, a decrease in volatility. Many trading platforms let you sell the straddle instead of executing each leg of the trade separately. By selling the straddle, you collect the option premium. You are thereby naked the straddle.
It’s nice to collect the premium, but the danger is that the underlying market will move enough that the option buyer can execute against you. When selling options, the exposure is technically unlimited. Taking the above example, if you collected 50 points for the straddle, but the S&P 500 dropped to 800, the put would then be worth at least 200 points and you would be down at least 150 points. At $50 per point, that’s $7,500. The loss could be more, depending on how much time value is remaining on the options.
The scantily clad straddle offers a level of protection for the options positions — thus, the position is no longer naked. Applying this to the previous example, if we got 25 points for the call and 25 points for the put, a pair of good until canceled stop orders in the S&P 500 would be appropriate (see "Protective orders," below). The orders would be:
- Buy one S&P 500 E-mini at 1025 stop GTC
- Sell one S&P 500 E-mini at 975 stop GTC
Once the straddle has been sold and the orders have been placed, there are three basic scenarios in which the trade makes a profit. In the perfect scenario, the market stays below 1025 and above 975. The trade collects the entire option premium on one side and part of or the entire option premium on the other side, depending on the close at expiration. If, in this case, the market closed at expiration at 1002, then the entire put premium was retained and 23 of the 25 points of the call premium were captured.
However, it is unusual that neither of the stops were hit. What normally happens is a trend develops in at least one direction during the trade’s life. In "Hit the stop" (below), it is assumed that the buy stop was hit and executed at 1025.
On the day of expiration, the market is at 1054. The call expires being worth 54 points. It was sold for 25 points, resulting in a loss on the call option of 29 points. However, you went long the S&P 500 at 1025, and it closed at 1054. The resulting gain on the S&P was 29 points. The long trade covered the call position. The other thing to remember is you collected all of the 25 points on the put. As long as the market remains above the put’s 975 strike price, the position will make money (see "On expiration," below).
Anything above 975 is profitable. Every price above 1000 achieves the maximum profit of 25 points ($1,250). If the market trends strongly in the direction of the initial stop, the trade will be profitable. Unlike other option writing programs that get hammered during a trend, the scantily clad straddle loves trending markets. It locks in the profit and covers the losing side.
Finally, instead of the market hitting your 1025 buy stop, let’s say it went down and engaged your sell stop at 975 and then continued down and closed at 900 on the day of expiration. You’d lose 75 points on the put (100 points value at expiration minus the 25 points collected in premium). But you’d also make 75 points on the short sale and wash out the put loss. Then you’d gain all 25 points on the call option because it expired worthless.