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Options investors have the unique ability to profit whether the market goes up or down — in fact, they can profit without even having to guess the direction it will go in. If you are expecting the market to make a big move in one direction or the other, but you aren’t sure which way it will go, all you have to do is use a straddle.
But what about the times when the market is stuck in a narrow trading range? If you think the market is not likely to go anywhere for a while, you should consider taking the other side of the trade and become the straddle writer by selling the straddle contract, also known as a short straddle.
Using the same example we used in the last section, with the PowerShares QQQ Trust (QQQQ) trading at $49.61, imagine that you were confident that the market was not going to decline or rise significantly in the long term. You could see that same straddle at the bid prices pays a slightly smaller premium of $7.89 per share or $789 per contract.
Now the trade is paying you the option premium up front, and you are forecasting that the QQQQ will not move outside a range of $7.89 above and below the $50 strike price. Selling or writing the straddle has a distinct advantage of “time decay” over a long straddle.
A short straddle will lose value to the buyer (“decay”) as time passes. If the market continues to oscillate between support and resistance levels, staying inside your straddle range, the straddle will lose value because it has less and less time to move outside the range that will make it profitable to a buyer.
Because the initial options you sold were at the at-the-money strike price, almost all of the total premium is time value, which presents a lot of opportunity for you.
The risk of a short straddle is that if the market moves a lot, the short option that is losing value could accumulate large losses. That is something to consider as you evaluate a short straddle as an opportunity in your own account, and you should have an exit strategy planned if the trade turns against you.
In the video below, we will walk through constructing short straddle and provide a few tips that can help you find the right opportunity. (If you cannot see the video below, please try refreshing the page.)
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