So far in the course, we have talked about using long or short options as a way to speculate on market direction. By doing so, you are making a projection about where the market is likely to go. But there are ways to trade options that take advantage of a more directionally neutral stance, where even non-trending markets offer opportunity. This section will discuss one such strategy.

Short straddles and strangles

This strategy relies on you selling two opposite positions on a currency pair with a put and a call at the same strike price. The call will lose value, which is profitable for you as the seller if the market drops. The put will lose value, which is profitable for you as the seller if the market rises. As long as the market moves, one side of the trade will lose while the other side gains. So won’t these two positions then just offset themselves? No. As the options seller, you can take advantage of the decay of time value on both options.

Time value is the loss in value of your options as they get older, and the further they go in the money. Since you’re the seller, that time value decay will create profits for you as you can later buy the options back for a cheaper price than you sold them. 

So you are basically betting the option that is losing value will lose it faster than the option that is gaining in value as the market moves.

This is a strategy that works best when you have a neutral outlook on market direction but are forecasting a trading range or lower market volatility, because profits will be made if the market stays within a certain range. You don’t care which way it goes as long as it doesn’t move outside that range.

The probability of profiting from this strategy is very high, but like trading the forex itself, there is some risk.

Let’s walk through the most common way this trade can be constructed.

Anatomy of a Straddle

The USD/CAD began to consolidate in late November 2008 and there was uncertainty which way the pair would go. The v-reversal in early November was very disruptive to the direction the fundamentals might have predicted to the downside, so it was likely the pair would channel for a time. This was a great opportunity for a short straddle.

Again, with a straddle you sell a call and put with the same strike price and expiration date. If the USD/CAD was priced at .9901 on 11/26 you could have sold a call and a put at strike prices of .9900 for 35 day expiration and be paid $310 per straddle. The $310 premium is the combined value of the call and the put.

For sake of explanation, let’s assume that you will not exit or alter the position until expiration. In this case, you have approximately 310 pips to the upside and 310 to the downside as a trading range. As long as the market expires within that range in 35 days you will retain profits in your position. That 620 pip trading range is quite wide so your probability of having a successful conclusion to this trade seems likely.

If you assume that the position was not modified in any way and left to expire in 35 days on 12/31 it would have been profitable. Because the market price was above the strike price you sold, the call will still have some intrinsic value, and that will offset your gains. In this case, the market expired at .9984, which makes the call worth 84 pips or almost $84. The put, however is worthless because it expired out of the money.

Your profits are equal to the premium you were originally paid, minus any intrinsic value one of the options has at expiration.

In the example above, we assumed that we would not modify our position at all. The good news is, you can exit and re-enter straddle positions during the period before expiration.

Adjusting Straddles

If one of your barriers appears to be in danger of a breach by the call or put, there is a good probability that you can actually get out of the trade and reset the position for a small profit or loss.

For example, if you had been trading this position in your real account you may have decided to adjust it in early December when the upper barrier was in danger. Let’s look at what the straddle was worth at that time.

As the market touched the upper barrier it was worth $270. That still provided a small profit and gave you an opportunity to unwind the position and resell another straddle.

 
Wrapping it up

Selling straddles is a simple strategy and requires very little analysis, and is a great strategy for channeling markets.  Here are a few tips that will help you as you practice implementing this idea:

1. Large amounts of volatility is bad for a short straddle

If you expect volatility to increase, such as before an expected announcement or during a market crisis, it is best not to use a short straddle. Time value may actually increase with volatility, which is bad for sellers.

2. Active management is subjective

Actively managing this position is up to you as the trader. You should expect to be actively engaged in monitoring technical levels, and your profit and loss in the position, making adjustments as the market approaches your expiration break-even barriers.  

3. Diversification is important

Don’t trade this or any strategy on a single pair. Diversify your efforts across a few pairs. That spreads your risk out without impacting the probability of having a profit. It can be discouraging if you only have one position in your portfolio and you go on a losing streak. Having more than one position will help offset losses and smooth your equity curve.

4. Risk

The risk in a short straddle can be large but is no larger than the risk of one short option. The market cannot trend both directions at the same time. So although you are short two options you are not more exposed.

However, if the market moves very fast, outside the breakeven range, losses can begin accumulating as one of the two options grows indefinitely. This means that a straddle must be monitored on a regular basis like you would any other forex position.

Watch the video below, then proceed to the next lesson: Covered Calls

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Humberto  - Video tutorials   |2009-02-06 15:31:15 NOt working..guys

Admin  - Works now   |2009-02-09 03:36:47 Sorry, one of those things that was lost in a server migration over the weekend. They work now. It may take a minute to load the player though.

Scott  - Income and Protection   |2009-11-04 17:23:15 Hi John, First, thanks for this, I'm learning a ton. My question regards hedging my currency risk exposure (I live in germany, but am paid in dollars). I'd like to try and generate some income while protecting myself from a big move against my exchange rate risk. Would any particular options strategy make sense? thanks! Scott

John Jagerson  - Income and protection   |2009-11-05 02:00:59 Well if you are concerned about the dollar losing value against the Euro you could go long the EUR/USD. That would hedge your personal risk and you could theoretically make a little income without damaging that hedge too much by selling calls against that long position. The other side to this is what happens if the EUR/USD drops. Of course in your case that might not be so bad since you are long the underlying cash market because you are paid in dollars, which could offset some of those losses. Also if that were to happen, those short calls could still provide some nice income.

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3.25 Copyright (C) 2007 Alain Georgette / Copyright (C) 2006 Frantisek Hliva. All rights reserved."