How to make Profit in a Neutral Market: Short Straddle Option Strategy

How to make Profit in a Neutral Market: Short Straddle Option Strategy

by Nilesh Jain Last Updated: 2017-03-16T04:30:00+05:30

A Short Straddle strategy is a race between time decay and volatility. Every day that passes without movement in the underlying assets will benefit this strategy from time erosion. Volatility is a vital factor and it can adversely affect a trader’s profits in case it goes up.

When to initiate a Short Straddle Options Trading Strategy?

A short options trading straddle strategy can be used when you are very confident that the security won’t move in either direction because the potential loss can be substantial if that happens. This strategy can also be used by advanced traders when the implied volatility goes abnormally high for no obvious reason and the call and put premiums may be overvalued. After selling straddle, the idea is to wait for implied volatility to drop and close the position at a profit. Inversely, this strategy can lead to losses in case the implied volatility rises even if the stock price remains at same level.

How to Construct a Short Straddle Options Trading Strategy?

A short straddle is implemented by selling at-the-money call and put option of the same underlying security with the same expiry.

Strategy Sell ATM Call and Sell ATM Put
Market Outlook Neutral or very little volatility
Motivation Earn income from selling option premium
Upper Breakeven Strike price of short call + Net Premium received
Lower Breakeven Strike price of short call + Net Premium received
Risk Unlimited
Reward Limited to Net Premium received (when underlying assets expires exactly at the strikes price sold)
Margin required Yes

Let’s try to understand with an example:

Nifty Current spot price Rs. 8800
Sell ATM Call & Put(Strike Price) Rs 8800
Premium received (per share) Call Rs 80
Put Rs 90
Upper breakeven Rs 8970
Lower breakeven Rs 8630
Lot Size(in units) 75

Suppose, Nifty is trading at 8800. An investor, Mr. A is expecting no significant movement in the market, so he enters a Short Straddle by selling a FEB 8800 call strike at Rs 80 and FEB 8800 put for Rs 90. The net upfront premium received to initiate this trade is Rs 170, which is also the maximum possible reward. Since this strategy is initiated with a view of no movement in the underlying security, the loss can be substantial when there is significant movement in the underlying security. The maximum profit will be limited to the upfront premium received, which is around Rs 12750 (170*75) in the example cited above. Another way by which this strategy can be profitable is when the implied volatility falls.

For the ease of understanding, we did not take into account commission charges. Following is the payoff chart and payoff schedule assuming different scenarios of expiry.

The Payoff Chart:

The Payoff Schedule:

On Expiry NIFTY closes at Net Payoff from Call Sell (Rs) Net Payoff from Put Sell (Rs) Net Payoff (Rs)
8300 80 -410 -330
8400 80 -310 -230
8500 80 -210 -130
8600 80 -110 -30
8630 80 -80 -0
8700 80 10 70
8800 80 90 170
8900 -20 90 70
8970 -90 90 0
9000 -120 90 -30
9100 -220 90 -130
9200 -320 90 -230
9300 -420 90 -330

Impact of Options Greeks:

Delta: Since we are initiating ATM options position, the Delta of call and put would be around 0.50.

  • 8800 CE Delta @ 0.5, since we are short, the delta would be -0.5.

  • 8800 PE Delta @-0.5, since we are short, the delta would be +0.5.

  • Combined delta would be -0.5+0.5=0.

Delta neutral in case of Short Straddle suggests profit is capped. If the underlying assets move significantly, the losses would be substantial.

Gamma: Gamma of the overall position would be Negative.

Vega: Short Straddle Strategy has a negative Vega. Therefore, one should initiate Short Straddle only when the volatility is high and expects to fall.

Theta: Time decay is the sole beneficiary for the Short Straddle trader given that other things remain constant. It is most effective when the underlying price expires around ATM strike price.

How to manage risk?

Since this strategy is exposed to unlimited risk, it is advisable not to carry overnight positions. Also, one should always strictly adhere to Stop Loss in order to restrict losses.

Analysis of Short Straddle Option Trading Strategy:

A Short Straddle Option Trading Strategy is the combination of short call and short put and it mainly profits from Theta i.e. time decay factor if the price of the security remains relatively stable. This strategy is not recommended for amateur/beginner traders, because the potential losses can be substantial and it requires advanced knowledge of trading.

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