Have You Ever Wondered What A "Naked T-Bill Straddle" Is?

This is one of expressions often used to make fun of complex financial instruments.   Since I recently had to complete a tax form involving straddles, for no reason that I could understand (that is why I use TurboTax to complete my 116 page tax return), my curiosity about this very suggestive term caused me to go look it up.

And no, it is not the X-rated version of Slim Pickens' ride  in Dr. Strangelove.  (I am sorry that you will never be able to unthink that image.)

A naked or sell straddle is what happens when you buy call and put options on an asset with the same strike price and expiration date.

If the asset price is pretty much unchanged at expiration date, you make a modest amount of money.  Big changes will lose you an immodest amount of money.

What are call and put options?  Options are derivatives: in the words of Warren Buffett "derivatives [are] weapons of mass destruction."  Anyone who remembers the 2008 crisis should remember that Collateralized Mortgage Obligations (CMOs) were the immediate cause of this global disaster.   (The idiot whose theories underlaid CMOs eventually went to work for the Bank of China, where it looks like his wondrous skills with understanding real estate markets have once again caused a fortunately localized disaster.)

Anyway, an option is a contract that allows you to either buy or sell an asset before a particular date at a particular price.  You pay a premium for this contract.  

A call option guarantees you the right to buy an asset at the strike price on or before the expiration date.

A put option guarantees you have the right to sell an asset at the strike price on or before the expiration date.

If you buy either type of option, the worst you can lose is the premium you paid for that option.  The best is that you guess correctly about the future value of that asset.  You bought a call option with a strike price 20% above the current price.  Before expiration date, you exercise that option to buy the asset at the strike price, sell the asset, and make 20% (which hopefully is more than the premium you paid for the option).

A put option is the reverse.  You are betting the asset price will be lower than the strike price.  If so, the person who sold you the put option must purchase the asset and sell it to you at the strike price.  If the asset is now worth 20% below the strike price, the firm that sold you the put option contract must deliver that asset at the strike price and likely lose piles of money.  This is called shorting the asset.

You may have heard about the GameSpot shorts squeeze.  The hedge fund that sold put options on GameSpot stock had the problem that they sold put options requiring purchase and delivery of more GameSpot stock than was up for sale. (After all, GameSpot was a clearly declining company so the stock price just had to fall.)  So buying existing GameSpot stock required paying an exorbitant price for the stock to get enough to meet those put options.  

Certain troublemakers bought GameSpot stock in time to drive the price way up because they recognized that the seller of the put options would never be able to buy enough stock at the current price to fulfill those contracts. Wealthy hedge fund (with strong Democrat connections) played with fire, got burned by a bunch of small investors, and went crying to Congress for protection from the smart little guys.

Anyway, if all of this sounds incredibly complex and risky you are correct.  The same aphorism that applies to commodities trading (another form of options) applies here as well: "How to make a small fortune in commodities: start with a large fortune."  Options trading is best left to rich people with excellent forecasting skills.  What they lose in a shorts squeeze on one contract, they hopefully make up on another contract.