What are you doing in a low volatility, sideways trading market? Are you sitting on your hands and “waiting it out”? Or are you taking advantage of the opportunity at hand? Did you even know there’s a way to trade a sideways market? I know many people will simply sit and wait when prices are just trading sideways without much of a trading range. They believe that there’s really no way to use the lack of volatility in their favor, but there’s actually very much a way to do exactly that. It’s called a ‘short straddle’, and it’s what many speculators and producers alike use at certain times of year to take advantage of a sideways market.
Now I’m sure you’re wondering, what is a short straddle?
Before we can talk about exactly what a ‘short’ straddle looks like, we need to nail down the definition of a straddle. A straddle involves buying (or selling) an at the money put and also buying (or selling) an at the money call simultaneously. To put it plainly, if corn is trading at $3.50, then a straddle would involve either buying or selling a $3.50 put and a $3.50 call simultaneously. Expanding that to a ‘short’ straddle is rather simple, it just means that you’re selling an at the money put and selling an at the money call together. So, in the example I outlined above, you’re selling a $3.50 put and selling a $3.50 call.
How exactly does this work in your favor if the market trades sideways? Well, when you sell the put and call to the market, you will be paid the premium for the options. If the price stays right around that $3.50 price, then the time value will be deteriorating as the days pass. When you buy an option, as I’m sure you know, the time value works against you. However, when you sell options, the time value works for you because there becomes less and less time for the option to move into the money. To put it plainly, you want the price of the underlying futures contract to go nowhere and finish right at the strike price of the put and call. But if it doesn’t, then you can still end up with a profitable trade, depending on how far away from that strike price it is.
Let’s look at that example:
Say you sell the $3.50 put for 10 cents and sell the $3.50 call for 10 cents. The market’s going to pay you 20 cents up front to sell that straddle. At the time of expiration, if the price is at $3.50, then you’ll get to keep all 20 cents, which is the optimal outcome. If it doesn’t finish right at $3.50, then you’re still going to be profitable if the price finishes within 20 cents of that number. If it finishes at say, $3.60, then the put will expire out of the money and the call will expire 10 cents in the money. In that case, you still finish with a 10 cent profit, which is the 20 cents you were paid initially less the 10 cents you lost on the call option.
Obviously, there’s risk with selling options, and if the price swings severely, then you could lose money on the trade. That’s why one of the keys to a position like this is to keep a close eye on it. Now if you prefer to sit and wait out a sideways market, then by all means, don’t do anything in these situations. But, if you’d rather take advantage of an opportunity and use the sideways markets to your advantage, then short straddles are the answer.