Risks of Short Straddles and Strangles
💡 Mastering Risk: Short Straddles and Strangles
In this lesson of the Masterclass, you will learn about:
- Risks of short straddles
- Risks of short strangles
- Understanding and managing them
- Important considerations for them
A short straddle involves selling a call and a put option on the same underlying cryptocurrency, with the same strike price and expiration date. It's a strategy that profits from a lack of volatility in the underlying asset.
Risks of Short Straddles
- Significant Price Movement: The primary risk with a short straddle is a significant price movement in either direction. Given the volatile nature of cryptocurrencies, this risk is amplified. A substantial move can result in significant losses since the potential loss for a short straddle is theoretically unlimited.
- Implied Volatility Increase: Even if the underlying price doesn't move significantly, an increase in implied volatility can inflate the value of the options, leading to potential losses when closing the position.
- Early Assignment: Especially if one leg of the straddle goes deep in-the-money, there's a risk of early assignment, which can disrupt the strategy and introduce additional risks.
Managing Short Straddles
- Position Monitoring: Regularly monitor the position and the broader market. Setting alerts for significant price moves can help in timely decision-making.
- Rolling: If one leg of the straddle is tested (i.e., the underlying price approaches the strike of one of the options), consider rolling that leg to a further out-of-the-money strike or to a further expiration date.
- Hedging: Using futures or the underlying cryptocurrency, hedge the position if the market starts trending strongly in one direction.
Short Straddles: A strategy that profits from lack of price action, its main risk derives from potential sudden volatility in any direction.
A short strangle involves selling an out-of-the-money call and an out-of-the-money put on the same underlying cryptocurrency, with the same expiration date but different strike prices. It's a strategy that also profits from a lack of volatility but offers a wider range for profitability compared to the straddle.
Risks of Short Strangles
- Significant Price Movement: Like the straddle, the primary risk is a significant price movement in either direction. The potential loss for a short strangle is also theoretically unlimited.
- Implied Volatility Increase: A spike in implied volatility can increase the value of both options, leading to potential losses even if the underlying remains within the range defined by the strikes.
- Early Assignment: There's a risk of early assignment, especially if the underlying price moves significantly, pushing one of the options deep in-the-money.
Managing Short Strangles
- Position Monitoring: Given the crypto market's volatility, it's crucial to monitor the position closely and be ready to adjust based on market movements.
- Rolling: If the underlying price approaches one of the strikes, consider rolling that leg to maintain the position's out-of-the-money status. This can involve adjusting the strike or extending the expiration date.
- Diversification: Consider diversifying by using short strangles on different cryptocurrencies. This can help spread the risk, especially if one cryptocurrency starts trending while others remain range-bound.
Short Strangle: Similarly to the short straddle, this strategy benefits from lack of volatility, although it offers a wider range for profitability in comparison.
Liquidity Concerns: Given the nascent state of the crypto options market, liquidity can be a concern, especially for less popular cryptocurrencies. Wide bid-ask spreads can make adjustments costly. It's crucial to trade these strategies on cryptocurrencies with a robust options market.
Regulatory and Platform Risks: The evolving regulatory landscape for cryptocurrencies can introduce significant market volatility. A sudden regulatory announcement can push the underlying price outside the profitable range for these strategies. Additionally, platform-specific risks, like hacks or insolvencies, can disrupt trading and risk management.
Skew and Surface Analysis: Understanding the implied volatility surface is crucial. A tilt in the skew can indicate market sentiment, which can be invaluable when setting up or adjusting these strategies. For instance, a pronounced skew towards puts can indicate a bearish market sentiment.
Margin Requirements: Both strategies require margin, and given the volatility of the crypto market, margin calls can be frequent. It's crucial to maintain sufficient capital to meet these requirements and avoid forced liquidations.
Which description best matches that of a short straddle?
A strategy that profits from lack of price action, its main risk derives from potential sudden volatility in any direction.
A strategy that profits from sudden volatility, short straddles are especially useful during bull markets.
A strategy that involves buying two call options at different strike prices simultaneously.