When the market has just made a dramatic move and you are expecting it to consolidate - you might consider selling a straddle. This strategy involves selling a call option and a put option on the same asset at the same strike price and expiration date. This gives you a known, but limited gain, but does expose you to unlimited risk - so you must be careful with this position and be confident of your assumptions. It is not suitable for all investors.
With this strategy, your gain is composed of the premium you received for the call and the put, less the commissions.
When we sell Straddle, the put and call that we sell are normally on over priced options that are at-the- money or close to it. We consider doing this after a dramatic move in the market, when we are expecting it to consolidate the move and digest its gains before moving again. Because of the dramatic move that was made, volatility is high, making the options we sell very expensive. Then as the market consolidates, volatility decreases and lowers the price of the options, increasing our profits when we buy back the options at a lower price to close our position. Decay also works in our favor with this position.
But be ready to buy back one of the options if there is any indication that the market will resume its trend or reverse direction. If it looks like the market will trend up, buy back the call; if it looks like the market will trend down, buy back the put.
It is also important to cover risks and caveats of this strategy.
The risk of this position is unlimited so you must be very careful. Remember that the commission you pay for this position will be higher because you are initiating two related option transactions.
It is important to analyze your expectations for the underlying asset and for the market before selecting your strategy.
