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A short straddle is a neutral options strategy that entails writing uncovered, or naked, calls and puts simultaneously, at the same strike price and expiration, on a certain underlying stock. With a short straddle, the potential for profit is limited, but the downside risk is not.

Setting up a short straddle

A straddle means to either buy or sell a call and a put option on the same underlying stock, at the same strike price and expiration. A long straddle consists of buying both a call and a put, and is essentially a bet on a large price movement in the stock. On the other hand, a short straddle consists of selling both a call and a put -- it is a bet that the stock will go nowhere.

For example, let's say that I'm convinced that Wal-Mart (NYSE: WMT) will stay around its current price for at least the next month or so. As I write this, Wal-Mart trades for just shy of $73, so I could set up a short straddle using options expiring in about four weeks as follows:

  • Sell one call option with a strike price of $73 for $1.27 per share
  • Sell one put option with a strike price of $73 for $1.38 per share

Keep in mind that since options contracts are written for 100 shares apiece, this trade would generate $265 in premium income for each call-put pair you sell.

The best-case scenario

The ideal case would be for the stock to close exactly at the strike price when the options expire. If this were to occur, you would keep the options premium you collected and both contracts would expire worthless, leaving you with no further obligation.

In our Wal-Mart example, this means that our maximum profit is $265, minus whatever trading commissions you pay.

Unfortunately, this isn't a perfect world, and this ideal case doesn't usually happen. So, let's take a look at the other ways this trade could play out.

Breakeven points and loss potential

Your breakeven points for a short straddle are the strike price of the options, plus or minus the total premium you collected. In the Wal-Mart example, this translates to $70.35 and $75.65. If the stock ends up within this range at expirations, you'll make money. If it ends up outside of this range, you'll end up with a loss.

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It's important to point out that with a short straddle, you can lose money quickly if the trade doesn't go your way. Let's say that a market correction hits and Wal-Mart falls to $60 per share. If this were to happen, you'd be sitting on a loss of more than $1,000. Because there is technically no limit to how high a stock's price can climb, the amount of money you can lose on a short straddle is unlimited. Make sure you keep this in mind as you decide whether the relatively small profit is worth the risk.

The bottom line on short straddles

Short straddles can lose money fast, so they are rarely the best approach to make a profit from a neutral outlook. There are several good alternatives, such as a butterfly spread, iron butterfly, or iron condor, just to name a few. All of these earn profits if the stock stays in a narrow range, but have components that help limit your loss potential.

I'm not saying that a short straddle never makes sense -- rather, I'm saying that you need to know exactly what you're getting into. And you'd better be pretty confident about the trade.