Selling Straddles Against a Portfolio
The owner of 100 shares of a stock may be willing either to buy more shares of the stock or to sell out at a premium. In such a situation he can sell a Straddle. A Straddle, as previously defined, is a combination of a Put and a Call, both at the market price of the stock. Let us say that a man sold a Straddle on XYZ at 50 for 90 days, and for it received $500 per 100-share Straddle. By selling the Straddle, he has contracted: (1) to sell 100 shares at 50 any time within 90 days when Called by the holder of the Straddle; (2) to buy 100 shares at 50 any time within 90 days if the holder of the Straddle Puts stock to him. If the Call is exercised, he will have sold his stock at 50 plus the $500 that he received for the option. If the Put is exercised, he will have bought stock at 50, which price is reduced to 45 by the $500 premium. But, you may ask, cannot both the Put and the Call be exercisedfirst the Call before expiration and then, after the Call has been exercised and still before expiration, the Put? Yes, that can happen. A Straddle consists of a Put and a Callboth separate contractsand the exercise of one does not void the remaining contract. What would be the result to the writer of the Straddle if both contracts were exercised? Well, in the example cited, the trader started with 100 shares. That stock was called, leaving him with no stock, but subsequently he had 100 shares Put to him, so after he sold 100, he then bought 100, and this brought him back to his original position of 100 shares. Finally, he was ahead by the $500 premium, which he received.
Selling a Spread Option
While a Spread is an option that isn't bought or sold too much, an explanation of it nevertheless belongs here so that the reader becomes familiar with all kinds of options.
Suppose that instead of selling a Straddle (both the Put and the Call at 50 for 90 days for $500), Mr. Trader sold a Put at 49 and a Call at 51that's called a 2-point Spread and instead of receiving $500, as he would for the Straddle, he receives $400 for the Spread. As a rule, the premium received by the seller of the option or paid by the buyer is reduced by $50 for each point Spread. Thus the Spread of 2 points reduces the premium by one point, or $100. This Spread option, like all other options, is traded by negotiation and is sometimes more difficult to make because the "maker" of the option would prefer to have more "cash in hand" and, therefore, would prefer to sell the Straddle. The only advantage in selling a Spread is this: if, at the expiration of the Spread, the stock which was selling at 50 at the making of the Spread is now selling between 49 and 51, chances are that neither the Put nor Call will be exercised; whereas if a Straddle at 50 has been sold, the chances are greater that at least one side of the Straddle, if not both, will be exercised.
Sale of a Strip
A quite recent addition to the family of Stock Options is a contract called a Strip. It is simply a Straddle with an extra Putin other words, a Put on 200 shares and a Call on 100. The seller of a strip at 50 would contract to buy 200 shares at 50 and/or sell 100 shares at 50. If the sale of a Straddle at 50 would bring the seller $500, then the sale of a Strip would bring about $700. Suppose that a man who had 100 shares of stock selling at 50 were willing to sell a Straddle for $500; that means that he would be willing to sell his stock at 50 plus the $500 premium and/or would be willing to buy 100 shares of additional stock at 50, which would be reduced in cost by the premium of $500 which he received.
In the sale of a Strip on the same stock, if the stock were Called, he would have sold his stock at 50 plus the $700 premium, or at a price equivalent to 57.
On the other hand, if the stock declined and the Puts were exercised, he would have to buy 200 additional shares at 50, which price would be reduced to 461/2 on each 100 by reason of the $700 premium received. Therefore, the question must be asked by the seller of a Strip, "Would I be willing to lose my stock at 57 and/or would I be willing to buy 200 additional shares at 461/2 ?" The increased premium for a Strip gives a higher selling price in case the Call is exercised. If the two Puts are exercised, the $700 premium received reduces the cost of the stock by 31/2 points for each 100-share Put. Whether a Straddle or a Strip should be sold (assuming that it is possible to sell a Strip) depends on the "market feel" of the seller of the contract.