Don't Forget Your Shorts

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Don’t Forget Your Shorts
I’ve recently written about the popular strategies known as straddles and strangles. For the most part, they were only discussed from the long side (in other words, buying the straddle or buying the strangle). Obviously, there is another side to this story, and that is the short side, selling the straddle or strangle.

There were two main reasons why I emphasized the long side. The first has to do with the fact that brokerage companies don’t let everyone trade naked short options. Each company has their own set of rules and requirements regarding which customers they allow to trade short options.


Factors taken into account include the customers’ length of options trading experience, income level, net worth and the size of their trading account. Some brokers require as much as $100,000 in an account before giving approval to trade naked shorts.

My second reason for focusing on the long side has to do with risk. Let’s take a look at the graphs of the short straddle and short strangle.


CLICK HERE FOR THE FULL-SIZED CHART

What’s the problem? Just look at the graphs and the problem becomes obvious - if the stock moves too far, then you’re faced with unlimited losses on the upside and huge losses on the downside. (The downside risk is somewhat mitigated by the fact that the stock cannot go below zero.)

So what can we do to reduce the amount of risk? There are at least 4 possibilities that we can examine:

1) Don’t trade them. This seems to me to be too drastic of an approach. There are times when options are trading with very large premiums. In those times, it makes sense to capture those premiums.

Of course there is risk associated with these trades, but we take risks all the time. Every time we cross the street or take a drive in the car we’re taking a risk. The key is to make sure the risk is small in relationship to the size of the possible gain.

2) Trade smaller - The second way to mitigate our risk exposure is to do smaller size. If your money management system allows you to risk $5,000 on a trade, then get out an options calculator and determine the absolute worst-case scenario . You might want to pad that estimate a bit to be more conservative, but then put on the trade.

Be aware that this is not the type of trade that you put on and walk away from. You should be watching the price movement of the stock and you should have your stops in place. Unless you’re dealing with an extremely liquid option, I usually recommend mental stops based on the price of the stock, not the options.

...to be continued in Part Two


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