Selling straddles is a great way to make money from time decay and falling levels of implied volatility. An example surfaced today in

American International Group

(AIG) - Get American International Group, Inc. Report

. With shares down $0.20 to $23.71, a December 24 straddle is sold on the stock at $3.44, 5000X. The position is basically a bet that shares will hold around these levels through the December expiration. If so, the strategist can make money from time erosion of both puts and calls. Falling implied volatility

IV can help the position as well. The risk from the straddle write is from a very volatile move higher or lower in the underlying stock. For that reason, most brokers require higher options trading approval level and substantial margin before allowing customers to implement the strategy. One way to hedge the risk, and lower the margin required, is to sell the at-the-money straddle, but also buy an out-of-the-money strangle -- a position called an Iron Butterfly.

The December 24 straddle on AIG was sold in morning trading Monday at $3.44. In this trade, 5,000 December 24 puts were sold at $1.82 and 5,000 December 24 calls at $1.62. The total net premium collected is a hefty $1.72 million on this trade (3.44X100X5000). The position is apparently opening because volume exceeds the existing open interest in both contracts. In addition, the strike price is near the underlying spot price and so this is an at-the-money straddle. The investor is writing both ATM puts and calls and betting that the stock will hold around $24 through the December expiration, which is in 39 days. The break evens of the trade are the strike price plus and minus the credit, or $21.56 and $27.44.

AIG lost 2.9% Friday after the company posted a much wider-than-expected quarterly loss, but the stock has been range bound for the past few months. In fact, AIG is at the same levels today as it was in early-August. Now that the earnings-risk has passed and the stock seems to be looking to hold around its 50-day moving average, heading into the historically quiet period for the equity market in December, the straddle write might make sense because it can generate profits if shares stay in the relatively wide range between $21.56 and $27.44, which is 9.1% below and 15.7% above current levels.

Meanwhile, implied volatility in AIG options, which hit 52-week highs of 77 on October 3, is up 2.5% to 54.5 today. The 52-week low of 23% dates back to mid-June. While it is unlikely that implied volatility will fall back towards those lows, the trend over the past month has been falling IV, which means that - all else being equal - the options are getting cheaper. The straddle write will also benefit if the trend of falling implied volatility continues.

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Regardless of the changes in IV, however, the maximum potential profit from the straddle write is the premium collected and happens if the stock settles at the strike price of the options at the expiration. At that point, both contracts expire worthless and the credit is kept. The position can also be closed out or offset at any time prior to the expiration through a closing transaction - i.e. buying the December 24 straddle.

The risk to writing a straddle is from a very volatile move higher or lower in the underlying. The downside is limited to the fact that a stock cannot fall below zero. In this case, the maximum potential loss if shares fall (and the puts are assigned) is equal to the strike price minus zero, or $24, minus the debit collected, which is $21.56 per straddle. There is theoretically no limit to the potential losses from a move to the upside. Given the high levels of potential risk from writing straddles, most broker firms require customers to post higher margin and have a higher level of options approval before initiating the strategy.

One way to limit the risk of a short straddle is to hedge the position by purchase an out-of-the-money strangle. For example, the investor can write the aforementioned December 24 straddle on AIG at $3.44 and buy the December 21 - 27 strangle for $1.35 - by purchasing December 21 puts for $0.85 and buying 27 calls for $0.50. The net result is a $2.09 credit on the four-way, which is significantly less than the $3.44 credit collected on the straddle. However, the downside is hedged by the 21 puts and the upside protected by the 27 calls. The max potential loss is $3 (difference between strike prices) minus the credit. In the hedged position, the strategist is risking $0.91 to potentially make $2.09 if shares settle at $24 in 39 days. The range of profitability of the overall position is between $21.91 (middle strike minus credit) and $26.09 (straddle strike plus credit).

When buying an OTM strangle around an ATM short straddle, the strategist has entered a position known as an Iron Butterfly. Like the short straddle, the spread is targeting a move to one strike price (middle strike of the iron fly) through the expiration. At that point, all of the options expire worthless and the credit is kept. When compared to the short straddle, the credit from the iron butterfly will be smaller. There will be higher commissions and the break evens are not as wide. The upshot is a hedged position with a similar potential payoff, but with less risk.

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At the time of publication, Fred Ruffy held no positions in the stocks or issues mentioned.