Common Mistakes to Avoid with the Short Straddle Option Strategy

Short Straddle Option Strategy
Short Straddle Option Strategy

Among the many intraday option trading strategies, short straddle is a popular one. It involves selling both a call and a put option at the same strike price and expiration date. 

This approach is often used when traders expect minimal movement in the underlying asset’s price. While the short straddle can be profitable, it comes with risks that you should know about so that you can avoid them. 

Mistakes to Avoid With the Short Straddle Option Strategy

1. Misjudging Market Volatility

The success of a short straddle depends largely on accurately predicting low market volatility. When you sell both a call and a put, you’re essentially betting that the underlying asset’s price will remain close to the strike price. If the asset experiences significant price movement, the risk of unlimited losses increases.

Avoid using this strategy when major news events, earnings reports, or economic announcements are expected. These events can create sudden price swings, which can be detrimental to a short straddle position.

2. Ignoring Implied Volatility

Implied volatility (IV) refers to the market’s forecast of the likelihood of price movements. When IV is high, options premiums are more expensive, and when IV is low, they are cheaper. One of the biggest pitfalls for traders is selling a short straddle when IV is low.

Look for opportunities to implement a short straddle when IV is high, which will allow you to collect higher premiums. This provides a bigger cushion against price movements in the underlying asset.

3. Underestimating the Impact of Time Decay

The short straddle benefits from time decay (theta), which erodes the value of the options sold. However, traders often overlook how quickly or slowly this decay occurs, which can lead to poor timing in trade exits.

Monitor the time until expiration carefully. The closer the options get to expiration, the faster the time decay accelerates. While this is favourable for a short straddle, it’s essential to stay vigilant and not hold the position beyond its optimal decay period.

4. Failing to Set Stop-Losses

One of the risky aspects of the short straddle is its theoretical potential for high loss if the market moves sharply in one direction. Many traders neglect to use stop-losses, hoping the market will reverse in their favour, only to see their losses magnify.

Always have a risk management plan in place. Setting a stop-loss can help protect your account from severe damage if the market moves against your position. A typical rule is to cut losses when the combined loss from the call and put option reaches a predetermined percentage of your collected premium.

5. Holding Through Expiration Without a Plan

Some traders hold onto their short straddle positions all the way to expiration, hoping that both options expire worthless. While this can sometimes result in maximum profit, it can also lead to unexpected large losses if the underlying asset moves significantly in the final days.

Have a defined exit plan. Whether you plan to close your position when you’ve captured a certain percentage of the premium or exit before a significant market event, always have a strategy in place to avoid last-minute surprises.

6. Ignoring Margin Requirements

The short straddle requires sufficient margin to cover potential losses. Since this strategy has unlimited risk, brokers will require a higher margin to maintain the position. Some traders underestimate the margin requirements and get caught off guard by a margin call, forcing them to close positions at unfavourable times.

Ensure you have a good understanding of the margin required for the short straddle and be prepared for any potential adjustments. Avoid over-leveraging your account, and always maintain extra cash to meet margin requirements.

7. Focusing Solely on Premium Collection

While collecting premiums is the key to making profits in a short straddle, focusing solely on the amount of premium can lead to poor decision-making. Traders may sell intraday option trading without fully evaluating the risks involved in case the underlying asset moves significantly.

Premiums should be balanced with risk. Avoid selling options simply because the premiums are high, as this often signals higher volatility and increased risk. Evaluate the market conditions, implied volatility, and potential market movement before deciding to sell.

Conclusion

The short straddle strategy can be profitable when the market is stable, but it carries significant risk if the market moves unexpectedly. Avoiding common mistakes and by carefully managing your risk, you can maximise the benefits of intraday option trading and the short straddle strategy.