The short straddle is dangerous because, well for one thing, both sides are short. Making things even riskier, one side or the other is always in the money.
Even so, the true risk of the short straddle might not be as severe as traders often assume. Consider how much risk is reduced in the following circumstances:
1. Premium is very rich. The best short straddles (a short straddle is selling a call and put on the same underlying, same strike and same expiration) are those that, given the at-the-money or -near-the-money conditions, offer overall very rich premium.
2. Expiration takes place in one month or less.
3. You plan to close both sides once time decay starts to hit; or if intrinsic value moves too quickly, you plan to roll forward (up in strike with the short call or down with the short put) and duplicate the strategy. The forward roll is another likely possibility. These options are so rich that rolling can be net profitable at least until enough time decay catches up and lets you close at a profit.
4. You also plan to cover the short call or put if circumstances make it necessary. You can cover with stock or long options, although that's an expensive proposition. The attractive shorts usually have a correspondingly expensive long, so cover with long options is not the best way out of the straddle.
5. You are willing to get exercised as long as it nets out to a profit for you.
Exercise risk is a serious problem for the short straddle, so this position has to be watched carefully to avoid expensive outcomes. Equally severe is the collateral requirement. For uncovered short positions, this is equal to the exercise value of the strikes. So a short 55 call requires $5,500 per contract on margin; and a short 45 put requires $4,500. That is a lot of capital to tie up without any equity or dividend income included.
Alternative strategies worth considering are the uncovered put by itself, which has the same market risk as the covered call; or the combination of an uncovered put with a covered call. If traders only pursue high premium income while ignoring risks, they are likely to end up losing rather than gaining.
Even though the straddle numbers look like the idea can work out, remember the one rule about short combinations: Even when they work on paper and even when they should work in practice, they can also go wrong, expensively and quickly. If you're going to do short straddles, keep them within sight of expiration and be willing to accept the risks. Also make sure you have the equity to meet margin requirements.
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