that max risk on a short put is possible, the past couple
of years contains a veritable who’s who of once-mighty
companies with double-digit stock prices that are now
either worthless or just plain bankrupt.
Think you can hit ’em right between the eyes? Or at
least the short strike price? If you believe that a stock is
going to stay in a very narrow range, the defined risk
trade is a long butterfly, which is long a lower strike
option, long a higher strike option, and short two
options at a strike in the middle. Its max profit occurs
if the stock is right at the middle strike price at expiration, and has a max loss limited to the debit paid. The
breakeven points are the lower strike plus the debit
and the higher strike minus the debit.
The much riskier version of this trade is a short
straddle, which is short a naked call and naked put at
the same strike price. Like the long butterfly, it loses
money if the stock rises or drops beyond the breakeven
points, which are the strike price plus and minus the
credit received. But unlike the long butterfly, the maximum loss on a short straddle is not definable because a
stock can theoretically go higher and higher without
end, or to zero. The credit for a short straddle can be
very high, and that large credit comprises the max
profit, which can be much greater than the max profit
on the long butterfly if the stock does land at the strike
price of the short options at expiration.
When would you consider a short straddle? One
scenario is when a stock has some major news
announcement, like earnings, coming up. Because of
the uncertainty of whether the stock might go up or
down on the news, and whether that move might be
big or small, the implied volatility in the stock’s options
increases. When that happens, the premium received
for selling the straddle can be very high. Of course, the
high volatility can also mean that the stock could make
a huge move either up or down, and cause major losses
in a short straddle. But if the news comes out and the
stock doesn’t move as much as the market expected or
feared, then the short straddle may drop in a lot of
value and profit.
Similar to a long butterfly, an iron condor is a trade
that profits if the stock stays in a somewhat wider
price range than what would work for a long butterfly
(for more on the iron condor, see “ 5 Trades Under
$1,000,” thinkMoney, Summer 2009). It’s a long out-
YOU CAN’T SEPARATE RISK AND
REWARD. IF YOU WANT LESS RISK, YOU
HAVE TO HEDGE THOSE SHORT OPTIONS
AND EAT INTO THAT POSITIVE TIME
DECAY. WANT MORE RISK, FOR HIGHER
POTENTIAL PROFITS? THEN YOU’D
BETTER PAY CONSTANT ATTENTION.
of-the-money put, a short closer-to-the-money put, a
long out-of-the-money call, and a short closer-to-the-money call. Its max loss is limited to the difference
between the strike prices of the long and short
options, and the profit is limited to the credit received.
The breakeven points are the short put strike minus
the credit and the short call strike plus the credit.
The scary version is to sell the short put and the
short call without the long options to limit the risk.
This is a short strangle, and because it takes in a larger
EACH OF THESE
HIGHER POTENTIAL PROFITS,
TAKING ON THE
< STOCK PRICE AT EXPIRATION >
< STOCK PRICE AT EXPIRATION >
SHORT STRANGLE: An iron condor without protective “wings” is a short
strangle, and might be used when you think the stock will trade in a wider
range up to the expiration of the options.
CALL RATIO SPREAD: An unbalanced butterfly without the lower long
call hedge is a call ratio spread, and might be used when you believe a stock
will trade sideways, with a possible upside breakout before expiration.