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Short Straddle Risks

The short straddle is dangerous because, well for one thing, both sides are short. Making things even riskier, one side or the other is always in the money.

Even so, the true risk of the short straddle might not be as severe as traders often assume. Consider how much risk is reduced in the following circumstances:

1. Premium is very rich. The best short straddles (a short straddle is selling a call and put on the same underlying, same strike and same expiration) are those that, given the at-the-money or -near-the-money conditions, offer overall very rich premium.

2. Expiration takes place in one month or less.

3. You plan to close both sides once time decay starts to hit; or if intrinsic value moves too quickly, you plan to roll forward (up in strike with the short call or roll down with the short put) and duplicate the strategy. The forward roll is another likely possibility. These options are so rich that rolling can be net profitable at least until enough time decay catches up and lets you close at a profit.

4. You also plan to cover the short call or put if circumstances make it necessary. You can cover with stock or long options, although that's an expensive proposition. The attractive shorts usually have a correspondingly expensive long, so cover with long options is not the best way out of the straddle.

5. You are willing to get exercised as long as it nets out to a profit for you.

Even though these numbers look like the idea can work out, remember the one rule about short combinations: Even when they work on paper and even when they should work in practice, they can also go wrong, expensively and quickly. If you're going to do short straddles, keep them within sight of expiration and be willing to accept the risks. Also make sure you have the equity to meet margin requirements. One last item: Since this position includes two short option positions, make sure you are approved for this type of trade.

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