Options trading is a risky business, but if you have a decent strategy for when to enter and exit the market, you can make a lot of money. Short Straddle is one such strategy.
A straddle is a neutral, speculative strategy that profits when the underlying stock price stays within a specific range during the option period. There are two types of straddles, namely Long and Short straddles.
If one is uncertain about how an underlying stock's price will move in the short term, this debit options trading strategy can be used. With this strategy, you will benefit from the underlying stock's volatility while also managing risk, as you know at what level your losses will never exceed.
In this article, we will learn what a short straddle meaning is and how one can make a profit with it.
What is Short Straddle?
A short straddle is an options strategy where an investor sells both a call option and a put option with the same strike price and expiration date. In this strategy, the trader bets that the underlying asset's price will fluctuate as little as possible throughout the options contract duration.
As the investor sells options, the premium he receives represents the maximum profit he can expect. They are motivated by the net credit he stands to gain or the sum of the call and put premiums.
This approach may pose a disadvantage because it exposes the trader to limitless losses, which is why only very experienced traders are likely to use this approach.
Understanding Short Straddles
Traders may use short straddles to profit from inactivity to minimize the risk of losing money on directional bets based on the assumption that the underlying asset will move upwards or downwards.
As a result, both the put and the call are expected to expire worthlessly. This will result in the investor receiving a return on the premium received at the time of the opening of the trade.
The short straddle owner faces assignment risk when the underlying asset does not close at or near the strike price at expiration. Traders will still make a profit if the premiums received exceed the difference between the asset value and strike price.
The method may benefit experienced traders who can profit from a potential drop in implied volatility. In this scenario, the call and put could be overpriced if implied volatility is higher than usual for no apparent reason. In this case, it is advisable to wait for volatility to decrease before closing your trade.
In simpler terms, this method is effective when there is little to no fluctuation in stock prices or minimal volatility. Time decay is an additional plus for the tactic. The straddle's valuation improves with each passing day of stable stock prices.
Example of a Short Straddle
In the short straddle example below, we will understand the straddle option better.
Consider Stock XYZ trading at 1000. Since at-the-money options are the most popular among traders, the strike price would be 1000.
Also, for the market premium, consider the following:
XYZ 1000 CE (Call Option) is trading at 160
XYZ 1000 PE (Call Option) is trading at 140
Using the short straddle strategy, you may accumulate a total premium of 300, i.e., 160 plus 140, if the underlying stock remains within a tight trading range. In a nutshell, earnings potential is limited by the sum of premiums less commission.
There are two possible breakeven points at expiry: the strike price plus or minus the entire premium collected.
First Breakeven point:
1000-300 = 700 (Strike price - Total premium)
Second Breakeven point:
100+300 = 1300 (Strike price + Total premium)
It is therefore clear that there are two breakeven prices, namely 700 and 1300.
In a successful short straddle strategy, trade requires that the price fluctuates between the trade's breakeven points (700 or 1300).
It is important to note that both the upside and downside of the stock market have the potential for limitless loss because stock prices have the potential to both rising and fall endlessly.
Suppose XYZ stock closed at the following prices on the day of expiration.
1. Expiry Price – 500
In this case, XYZ 1000 CE call option would not be exercised; the 160 premium remains yours.
A put option, XYZ 1000 PE, with an intrinsic value of 500, would now be executed by the option buyer.
Accordingly, your loss would be equal to -500 plus 140 (the amount of the premium you keep): -360.
This represents a total loss of -200 (-360 plus 160).
2. Expiry Price – 1000
As a result of this situation, the trader would be able to earn 300, which is the best possible outcome (sum of both the premiums).
The strike price equals the closing market price, so both contracts are worthless upon expiration, and the entire premium received will be retained.
3. Expiry Price – 1500
It is like Case 1; XYZ 1000 PE put option would not be exercised; the 140 premium remains yours.
A call option, XYZ 1000 CE, with an intrinsic value of 500, would now be executed by the option buyer.
Accordingly, your loss would be equal to -500 plus 160 (the amount of the premium you keep): -340.
This represents a total loss of -200 (-340 plus 140).
For comparison, the table below shows the prices at which other contracts expire:
If you're having trouble deciding all these, utilize the Short straddle calculator available online.
When Does This Strategy Work?
As seen from the examples, the trader might use this technique if they think the asset they are investing in won't move significantly up or down (range-bound market).
When stock prices are volatile, they may fluctuate between breakeven and profitable levels, but to be profitable, they must remain within the breakeven points.
The best time to use a short straddle strategy is during low market activity, such as between significant news releases and earnings reports or during a period of no significant market movement.
A more extended expiration date on the options contract helps the trader better prepare for the unexpected. Still, it's best to refrain from trading through this method if the options seem overpriced.
To sum up, it is a neutral strategy that usually generates a profit when the underlying stays within a specific range. The investor will profit even if the stock price does not change.
For experienced traders, low implied volatility presents an opportunity to profit from short straddles by locking in two upfront premiums during periods of flat prices.
Since stock prices may go up or down indefinitely, it's crucial to remember that any move in either direction might result in a devastating loss.
However, there is an opportunity for gain from premium receipt so long as stock prices are estimated to remain within the range of two breakeven values.