Short Straddle: Traders use various options trading strategies developed for different market conditions to analyze and make informed decisions.
In this article, we shall explore one neutral options strategy, the short straddle. We shall expand the knowledge of option strategies by understanding the working structure with an example of a short straddle strategy.
Table of Contents
What is Short Straddle?
The Short straddle strategy is a multi-leg options trading strategy designed to be used when a range-bound movement is predicted in an underlying security.
The strategy involves two legs, one call option and one put option. Here one at-the-money (ATM) Put option and one at-the-money (ATM) Call option of the same strike price is sold in an underlying security with the same expiration.
This strategy is useful when an underlying asset is expected to be neutral without any directional bias. To be profitable in this strategy the underlying security should stay near the strike price of the option sold with a minimal movement upon expiration.
A short straddle strategy should be avoided when directional movement in the price of an underlying asset is expected.
To deploy the short straddle strategy, first, we need to construct the two legs of the options required.
The two legs are:-
- First leg:- Sell one at the money(ATM) Put option. Here, the strike price nearest to the spot price is selected.
- Second leg:- Sell one at the money(ATM) call option. The strike price in this instance is the same as the first leg.
Let us understand the above construction clearly with an example.
Assume Nifty 50 is trading around a spot price of 20070. The market might stay sideways and expire nearest to the sell-strike option contracts. As we are sure about the range-bound market without any trending scenario predicted, we shall deploy the short straddle strategy. Here, the 20070 spot price of Nifty 50 is rounded off to the nearest strike price, which is 20070.
The option legs for the assumed spot price of 20070 nifty 50 are as considered below:-
- Sell one lot of 20050 strike price put options contract, the premium of Rs 96 (say) is received.
- Sell one lot of 20050 strike price call options contract, the premium of Rs 148 (say) is received.
Here total premium is calculated as the addition of premiums received in both legs. In the above example total premium accounts to Rs. 244.
I.e (96+148)= 244.
As we are selling the contracts in both legs, the margin required to deploy this strategy is more compared to other option strategies. For the above example, the approximate margins required will be around 1.4 lakhs to deploy this strategy for one lot of nifty 50.
Maximum Profit and Maximum Loss
- When the underlying security expires at the strike price, the strategy makes a maximum profit. It is calculated as the sum of the call premium and put premium. Here one lot of Nifty has 50 shares.
The Maximum profit here would be
= 96+148= 244(Total premium)
= 244 x 50
- The maximum loss in this strategy is unlimited. When the market becomes directional and as the spot price moves away from the strike price in either direction, the loss starts to incur upon expiration.
Short Straddle – Breakeven points
The strategy consists of two break-even points:-
- Upper breakeven point = strike price + total premium.
I.e 20050+244=20294. If the spot price moves above this point, the strategy starts to incur a loss upon expiration.
- Lower breakeven point = strike price – total premium.
I.e 20050–244= 19806. If the spot price moves below this point, the strategy starts to incur a loss upon expiration.
From the payoff chart, it can be understood that:-
- If the price of an underlying security expires between the upper breakeven and lower breakeven point, the strategy will make a profit.
- If the price of an underlying security expires above or below the upper and lower break-even points, the strategy will incur losses.
- When there is the expectation of sideways movement in the market, this strategy is very profitable.
- Option legs can be adjusted based on market movements for higher profitable ratios.
- The strategy gains the effect of theta decay every day.
- The margin required is quite when compared to other option trading strategies
- If the market becomes directional, the strategy incurs a loss.
- The increased volatility harms the strategy.
Having understood the short-straddle options strategy, we shall conclude that the strategy works well in the rangebound market condition. Here one can take advantage of theta decay during expiries for the fullest of profits in this strategy. If the market becomes directional then the traders can make huge losses. With a better understanding of this strategy, one can adjust the option legs to improvise the setups with good risk-reward ratios. A profitable trader always follows risk management to be profitable in the long run.
Written by Deepak M
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