Chapter 8

Short Straddle Option Strategy

This is one for the fence-sitters. You know those people who can’t make up their minds, find merit in both sides of an argument? That could happen in the markets too. There are times when traders feel a security could be ‘indecisive’ and not move, or move very minimally in either direction - up or down. The Short straddle option strategy is tailor-made for those occasions. 

Why would you use this? 

A trader will enter into a Short Straddle if they believe that the underlying will not be volatile just before expiry. The trade works best when the underlying is more volatile prior to entering the trade and then becomes less volatile during the life of the options. The trader doesn’t have a specific forecast of bullish or bearish but will be successful if little movement in the security occurs

How do you construct it? 

A Short Straddle consists of selling both a call and a put for the same strike price and expiration date. For example, if the underlying is trading at 395 and you believe that the stock won’t move much from this price in the near future, you could sell a straddle. 

You could select any strike but as an example, you could sell a call on the 395-strike and you would collect a premium of 6.43. You would also sell a put on the 395-strike which would earn you the premium of 6.32. The total premium collected is 12.75.

Illustration 1

What is the maximum profit? 

The maximum profit occurs if the underlying closes exactly at the shorted strike price. This means that neither the shorted call or put has intrinsic value resulting in the trader keeping the entire premium initially collected. 

In the above example, the maximum profit is the initial collected premium of 12.75.

Key Formulae

• Short Straddle Profit = Short Call Profit + Short Put Profit
  • Short Call Profit = Call Premium – Max(0, Underlying Price – Strike Price)
  • Short Put Profit = Put Premium – Max(0, Strike Price – Underlying Price)

What is the break-even point? 

A short straddle has two break-even points. 

• The first break-even point is the strike price minus the premium received to enter the strategy. 
• The second break-even point is the strike price plus the premium received to enter the strategy. 

Unlike with a long straddle, the break-even point is not the point where the strategy becomes profitable. Because this is a short position, the break-even point is where we have lost the premium received due to market movements and our position turns negative. 

In illustration 2 below, you can see two sections that are shaded red: one to the left of the 395-strike price and one to the right of the 395-strike price. Since the total premium received is 12.75 to enter this example short straddle, the two break-even points would be 382.25 (395 – 12.75) and 407.75 (395 + 12.75).

Key Formulae

• Short Straddle Break-even Point #1 = Strike Price – Net Premium Received
• Short Straddle Break-even Point #2 = Strike Price + Net Premium Received

What is the maximum loss? 

The maximum loss of a short straddle is theoretically unlimited. With a long call option, the gain is theoretically unlimited because the underlying stock can go up in price infinitely. By shorting a call option, the trader is exposing themselves to a theoretical limitless loss. 

A short straddle also consists of a short put option. The gain of a long put option is capped at the value of the underlying because the lowest price that the underlying can fall to is zero. Alternatively, if a put option on a stock that has a value of 100 is shorted and if this company goes to zero, the trader shorting this put option would lose 100.

Illustration 2

Short Straddle Scenarios using Historical Data

Let’s discuss a few examples using real market data to understand the opportunities and risks associated with straddles.

Scenario 1 – Underlying stays between the break-even points

The Situation:

• The trader believes the Nifty won’t move from its current price over the next week. Currently, the Nifty is trading at 17,576.85.
• The trader shorts a call and a put to create a short straddle strategy. The strike price selected is 17,600 and the expiration date is one week in the future.
• The short call provides the trader with a premium of 240.60. The short put provides the trader with a premium of 253.55. The total premium collected for this strategy is 494.15.
• The two break-even prices are 18,094.15 (strike price + straddle premium of 494.15) and 17,105.85 (strike price – straddle cost of 494.15).
• In order for the short straddle to maintain a profit by retaining the premium collected, the Nifty needs to stay within these two break-even prices.

What happens:

• Over the course of the next week, the Nifty stays relatively flat and closes at 17,605.85 on expiration.
• The underlying price is between the two strike prices so the trade is profitable.

Trade Results:

• The call option has a strike price of 17,600. With the underlying price of 17,605.85, the shorted call option has a value of -5.85. The initial premium received was +240.60 so the net gain on the call leg of the strategy is 234.75.

• The put option also has a strike price of 17,600 and with the underlying price above this put strike, it is out-of-the-money. Shorting this put option yielded a premium of 253.55. This put option expires worthless so the entire premium is retained by the trader.

• The net profit of the short straddle is 488.30. Overall, the trader is able to retain 98.8% of the initial premium received (488.30 / 494.15).

Scenario 2 – Underlying closes outside of one of the break-even points

The Situation:

• The trader believes the Nifty won’t move from its current price over the next two weeks. Currently, the Nifty is trading at 16,628.00.
• The trader decides to enter into a short straddle strategy.
• The strike price selected is 16,650 and the expiration date is two weeks in the future.
• The short call provides the trader with a premium of 253.45. The short put provides the trader with a premium of 246.85. The total premium collected for this strategy is 500.30.
• The two break-even prices are 17,100.30 (strike price + straddle premium of 500.30) and 16,099.70 (strike price – straddle cost of 500.30).
• In order for the short straddle to maintain a profit by retaining the premium collected, the Nifty needs to stay within these two break-even prices.

What happens:

• During the first week, the Nifty traded down 1.6% to 16,356.25. This is still above the lower break-even point of 16.099.70. Despite being down 1.6%, the Nifty needs to be down a total of 3.2% in order for the trade to result in a loss.
• Throughout the second week, the Nifty continues to trade down to 15,360.60. This is a total Nifty loss of 7.6% over the two-week period.

Trade Results:

• The shorted call option had a strike price of 16,650.
• The Nifty would need to close above this price in order for the trader to not keep the entire premium collected. Since the Nifty closed down to 15,360.60, the trader retains the full premium of 253.45.
• The Nifty closed 1239.40 below the shorted put strike price of 16,650. This is also 739.10 below the lower break-even point.
• Despite initially collecting a premium of 500.30, the trader lost this plus an additional 739.10.
• While the trader can collect a substantial premium upfront, the short straddle exposes the trader to the risk of not only losing this premium but far more.

To Conclude:

• Use if you believe the underlying will not be volatile just before expiry.
• This works best if volatility decreases during the life of the options.
• Trader does not have a bullish or bearish outlook, benefits if any movement occurs in the security.
• Construct a Short Straddle by selling both a call and a put for the same strike price and expiration date.
• Maximum profit occurs if the underlying closes exactly at the shorted strike price.
• A short straddle has two break-even points.
• Trader's position turns negative at the break-even point.
• The maximum loss of a short straddle is theoretically unlimited.

Key Formulae

• Short Straddle Profit = Short Call Profit + Short Put Profit
  • Short Call Profit = Call Premium – Max(0, Underlying Price – Strike Price)
  • Short Put Profit = Put Premium – Max(0, Strike Price – Underlying Price)
• Short Straddle Break-even Point #1 = Strike Price – Net Premium Received
• Short Straddle Break-even Point #2 = Strike Price + Net Premium Received
• Break-even price #1 = Strike price + Straddle premium 
• Break-even price #2 = Strike price – Straddle cost 

A short straddle is thus, the polar opposite of a long straddle. Quick recap so you know the difference - 

• A trader will enter into a Long Straddle if they believe that the underlying will be volatile before expiry. A Long Straddle consists of purchasing both a call and a put for the same strike price and expiration date. 
• In a Short Straddle, traders believe there will be minimal or no volatility before expiry. A Short Straddle consists of selling both a call and a put for the same strike price and expiration date.

Easy hack to remember this: you buy when you go long and sell when you go short. 

See you in the next chapter.