There’s a profound mental shift that happens when you flip from being in positions where bad luck could damage or ruin your trading account, to being in a position where the unexpected might actually make you a ton of money!

For options traders, an excellent example of these two positions is a short straddle vs. a long straddle.

In a short straddle, a trader is naked short an equal amount of calls and puts at the same strike and expiration. The PnL graph of a hypothetical 100-strike short straddle looks like this:

You’ll notice that as long as the underlying price (as displayed along the x-axis) stays +/- $20 from today’s price of $100, the trader will likely earn a profit as options expiration approaches.

Traders like these trades because they are high-probability bets, meaning that one has a better-than-average likelihood of earning a profit. Of course, when winning odds are favorable, the payoff usually isn’t all that high. And even worse, if the unexpected happens and a large directional move materializes, not only can you lose a lot of money, but your losses are theoretically unlimited. These losses also get increasingly worse (thanks to negative gamma) the further the market moves away from your short strikes.

I’ve been on the ass-end of moves like this before – and it’s never any fun. Ever. [Read more…]