An options strategy that profits when a stock exhibits no price movement is a short straddle. To execute this trade, sell a call and a put on the same stock at the same strike price and with the same expiration date. When properly chosen, the profit is the sum of the two premiums minus fees and commissions. When the market remains quiet, this is a profitable trade but has risks on the upside and downside. Thus, this strategy requires constant attention and the willingness to exit quickly to avoid substantial loss.
When Is a Short Straddle a Good Strategy?
Because of the potentially unlimited risk in both directions with this strategy, it needs to be applied to carefully chosen stocks in carefully chosen market conditions. The strategy has a margin of error equal to the two premiums (minus fees and commissions) so the trader does not need to find a stock that exhibits zero price movement until expiration. And, anyone who uses this strategy needs to be alert for any surprises that will drive the stock in either direction. To the extent that your market forecast for minimal price volatility is correct, this is an excellent strategy.
Options Strategy Contrary to Market Consensus
To the extent that the market believes that a stock will trade with little volatility, its option prices will be low. To the extent that the market believes there will be extreme volatility, options prices will be high. For this trade to be profitable there need to be too things. The market needs to believe that a stock price will be higher than you think it will. And, you need to be right in your assessment so that the stock price changes little if at all until your contracts expire. Thus, this is a contrarian trade with the potential for a comfortable profit but the risk of huge losses. In reality, you will rarely see huge losses as traders will exit this trade as soon as they see it going badly.
Predicting Reduced Volatility
This trade can be a good one to make if you are good at seeing through market hype and judging both fundamentals and reliable indicators of market sentiment. When this is the case, you will be good at predicting reduced volatility. For example, both call and put prices are high because general unease about some issue related to a stock or even the overall economy. You take advantage of this fact by selling your call and put at higher-than-expected prices. When market unease drops off, two things happen. The stock stays in its trading range which gives you a profit with this trade. And, the “new” prices of calls and puts at your strike price are much lower. You could, in fact, exit the trade with a profit at this point although most traders would take advantage of the now-low volatility and wait until expiration for maximum profits.
Time Value of a Short Straddle
The potential profit from this strategy can increase almost exponentially as time passes. This is because the likelihood of a change in the stock price becomes less as expiration approaches. Thus, you need to set up this strategy before time decay or time erosion becomes an important factor and experience your profit as it does.
Early Assignment Risk
When the stock in question is close to its ex-dividend date there will be an early assignment risk with this trade. This generally happens when the value of the dividend is greater than the time value of the call option. If you see this coming, you need to decide whether or not to exit the short call position or even exit the entire trade. You will do this to avoid being in a short stock position.