What Is A Short Straddle?
A short straddle is an options trading strategy that involves selling a call option and a put option of the same strike price and expiration date.
It is a neutral options strategy and the maximum profit is the premium collected by the trader while selling the call and put options. The potential loss in this strategy can be unlimited, so this options trading strategy is for the most advanced trader with lots of experience.
Table of Contents
Construction of Short Straddle Options Strategy
To create a short straddle options strategy you need to follow the steps below;
- Sell one at-the-money call option (ATM) at a specific price.
- Simultaneously sell one at-the-money put option (ATM) at a specific price.
Understanding The Short Straddle Options Strategy
Short straddles options strategy allows investors to make a profit from the lack of movement in the underlying security, rather than placing directional bets expecting for a big move either upside and downside. Premiums are collected as profit meanwhile the position is opened with a goal and let both the put and call options expire worthlessly.
Still, there is a very low probability that the underlying asset price closes exactly at the strike price at the expiration, and that leaves the short straddle options trader at a greater risk. However, until the difference between the underlying asset price and the strike price is less than the premiums received, the options trader will make a profit.
Seasoned options traders may run this strategy to take benefit of a possible drop in the implied volatility. If the implied volatility is extraordinarily high without an apparent reason, the call and put options may be overvalued. In that case, the goal of the investor should be to wait for volatility to fall and then close the open position and book the profit without settling for expiration.
Short Straddle Options Strategy Profit and Loss
The short straddle is a limited profit, infinite risk options trading strategy that is used when the options trader believes that the underlying stock will encounter very little volatility in the near term.
Maximum Profit
- Maximum Profit = Net Premium Received – Charges Paid
A maximum profit in the short straddle options strategy can be achieved when the underlying security price at the expiration date is quoting at the strike price of the options contracts sold. At that price, both options will expire worthlessly and the options trader will get to keep the entire premium as profit.
Maximum Loss
- Maximum Loss = Unlimited
The maximum loss in this strategy is theoretically infinite and a large loss for the short straddle can occur if the underlying asset price makes a sharp move in both upwards or downwards movement at expiration, as a result of which the short call option or the short put option will expire deep in the money.
Breakeven
- Upper Breakeven Price = Strike Price of Short Call + Net Premium Received
- Lower Breakeven Price = Strike Price of Short Put – Net Premium Received
To calculate the breakeven price for the short straddle options strategy, you can use the above two formulas.
Example
Suppose there a stock trading at $100 witch a contract size of 100 July expiry and to employ the short straddle options strategy, the trader needs to sell a $100 call option at $5 and a $100 put option at $5.
In the above trade, the maximum profit the trader can get is the combined premium of both options; $5 + $5 = $10 x 100 = $1000. The maximum loss occurs if the stock price moves significantly above or below the strike price.
Suppose the stock expires at $120, then the put option becomes worthless means a gain of $5 x 100 = $500 and the call option will be valued at $20 means there will be a loss of $15 x 100 = $1500, so the trader will suffer a total loss of $10 x 100 = $1000.
In another case, if the stock expires at $104, the put option will expire worthlessly means a gain of $5 x 100 = $500 and the call option becomes $4 means a gain of $1 x 100 = $100, so there will be a total gain of $600.
Limitations of Short Straddle
Like the short strangle options strategy, the short straddle options strategy is also a limited profit but unlimited loss strategy and using it without any prior experience can get in some huge loss in volatile market conditions.
Key Takeaways
- Maximum profit in short straddle options strategy is limited to the premium received by the trader while placing the sell orders.
- Maximum loss can be unlimited on both upside and downside.
- Maximum profit achieved in this strategy when the price of the underlying stock is equal to the strike price of short call option and option.
- Loss occurs in this strategy when the price of the underlying stock is greater than the strike price of short call plus net premium received or the price of the underlying stock is less than the strike price of short put minus the net premium received.
Conclusion
This strategy is mainly for advanced traders who might run this strategy to take benefit of a potential decrease in implied volatility (IV). If the implied volatility is abnormally high for no obvious reason, the call option and put option might be overvalued. After implementing the strategy, the plan is to wait for volatility to fall and close the position at a good profit.
