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

Nilesh Jain

16 Mar 2017

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.

Have Referral Code?

Similar articles

  • Responses
  • Patidar Samaj

    - 2 hrs ago

    This article claims RJio was given a "Backdoor Entry" into the 4G Based Voice Routing. The peculiar aspect is without the Voice License, Rjio would have been a mere ISP. With the license, it is now a holistic communications service provider, with ability to exponentially scale the bouquet of products. The events indicate it was meticulously planned way before the auctions because the auctions were clear on the agenda: 4G for internet only.

Load More
mutual-fund

Why to Choose Mutual Funds Instead of Directly Investing Into Equities?

Whether to invest in equities or mutual funds is a question that has plagued every investor. As someone who needs the best value for his/her investment should you invest in equity directly or via mutual funds?

Let’s start by first understanding what these two terms ‘equities’ and ‘mutual funds’ stand for-

Equities- Equities generally represent ownership of a company. If you own any equity in a company, you are a part owner of the said company (depending on how much equity you own).

Mutual Funds – It is an investment scheme which is professionally managed by an asset management company. It pools together the resources of a group of people and invests their money in equities, debentures, bonds and other securities.

Why choose mutual funds over equities?

For people who’ve never invested in either stocks or mutual funds, it is hard to know which is better and where to start. Broadly speaking, if you are a novice investor, mutual funds are not only less risky but also way easier to manage. Here are some ways in which investing in mutual funds is beneficial as opposed to investing in equities -

Diversification

Mutual funds provide more diversification as compared to an individual equity stock. When you invest in equity, you are investing in a single company which has its inherent risk. For example, if you invest Rs.20,000 in buying equities of one company, you could face a total loss if that particular company performs poorly in the market.  

If you invest the same amount in mutual funds, it will be invested in different kinds of stocks and financial instruments, high-risk and low-risk both, so you might not face total loss even if one company does poorly.

Scale of Investment and Lower Costs

For an individual investor buying and selling stocks is a difficult task due to its high price. Thus, any gains made from stock appreciation are nullified if the overall trading costs are considered. Comparatively with mutual funds, as the money is pooled from a large number of investors, the cost per individual is lowered.  

Another advantage of mutual funds is that you don’t need to invest large sums of money. Buying equities for a profitable venture needs huge amounts of money, a minimum of few lakhs. With mutual funds, you can start with Rs.1000 and earn profits on that as well.

Convenience

Keeping an eye on the markets everyday is a time-consuming business, especially if you are investing as a side gig. There are people who spend their lives studying the market and still end up sustaining heavy losses. Though investing in mutual funds does not guarantee high returns, it is stress-free and needs less work as compared to investing in equities.

To sum it up

It is important to remember that mutual funds have their own disadvantages as well. Thus, as with any financial decision, educating yourself and understanding the suitability of all the available options is the ideal way to invest. 


Banner

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

Nilesh Jain

16 Mar 2017

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.

Have Referral Code?