What's the best way to hedge risk if the underlying is moving out of the zone on the upside? Buy OTM call at the next strike? Thanks!
It is extremely hard to say. The two forces are 1) Continous hedging with the underlying is expensive, especially short gamma. 2) Hedging with other options caps your gamma, and is cheaper, but cuts into profit potential. 2 is probably the preferred method, unless you have super cheap commissions and specialized software, or if you are an options mm, and even then the use of 2 is probably still in the toolbox. 2 has a name, it is called a Condor (Iron).
Buying OTM call at next strike is one way. Buying synthetic stock ATM is another (a bit cheaper than adjusting with the underlying). And you must always consider the possibility of simply folding, especially if you are near-month or in a volatile underlying or some significant news is upsetting the apple cart. Good to decide about these things before initiating the straddle.
I employ iron butterflies. Sell the ATM, near money call/put and buy a call/put OTM for protection. I believe the comfort of protection far outweights the inflated cost of it. If you want to manage these aggressively and stay delta neutral, you will be closing out winning shorts and replacing them, depending on market and volatility movement. Otherwise, sit still and plan to exit the ITM side (exit as a bull put spread or a bear call spread separately) the week of expiration and the sooner the better to capture remaining time value. You can allow the winning side to expire, but of course, there is risk in that also.
I'd argue that if you feel a strong need to hedge your short straddle positions, you shouldn't be short straddles.
I have to disagree. Many professional traders, per Larry McMillan, use IB's. Short and long straddle positions are really excellent strategies, for you do not care about direction (for long straddles, I actually do care about the size of the movement than the direction). By staying delta neutral, you are gamma scalping or reverse gamma scalping--whatever terms you like to use. The best traders I can spoken with say that option positions/strategies are not static. For best results, they need to be managed. Take the long straddle. You can actually make money on both legs--we see lots of swings and the long straddle benefits on both sides. My point--you do not just sit on your option positions hoping and praying.
Funny you mentioned Nick Leeson. A trader many years ago. Made a mistake and went long instead of short a specific option. ( I told him to go short at a specific price) I got a dreaded call with the "I need you to help me get out of this position" I come by and find out he made a big oops! It took all day to correct the trade by unwinding this long options position carefully over the day to minimize the problem. Losses on the books but it was managable but it was a loss. I wonder if Nicks story about using the error account initially for that mistake is true because a 20K loss on a mistake is not really that big of a deal, shit happens sometimes. Just don't do it twice
I would like to add a question to this. Looking over this strategy I have found people to be in two camps. 1) They tweak twiddle and fidget 2) They sit still and if things get hard take action (eg rolling or just getting out of the trade) I tend to be in the second camp. I have tried to befriend myself with the tweaking and twiddling, but just can't. The reason is that it seems to me adding complexity on complexity. Selling premium is a relatively simple strategy, and by adding on complexity I can but help and wonder if you are not playing games? I personally feel that selling option premium is about managing your cash flow and playing the game of probability. I say it is akin to selling insurance. For the most part you make money, but sometimes there is a hurricane in Canada and you have problems. Thoughts?
In my experience, sitting tight is not an option. You can actually avoid that max paper loss by taking some warranted action. Yes, iron condors and butterflies rely on reversion theory--that the market always rebounds back to its starting placing before it advances or declines. Well, if that happened every time, then everyone would be using these strategies. McMillan has suggested exiting the winning short option at some point (I like to use 75-80% of its value) and "wait" for the underlying to rebound so that the other short option can be exited with a profit. This is a pretty aggressive treatment, and of course, your profits will be maximized if the market behaves this way. Others like to "roll," using closer to the money shorts, for example. Here is the problem I see with an extended move that doesn't rebound--the positions do not stay delta neutral. Once the underlying reaches a certain point, the winning short options stop going down in value as quickly as the loser increases in value. So, what is the point in keeping that winning short option? There really isn't one--hence the rolling (to try to stay more delta neutral) or the exiting of the winner.