What is a Short Straddle Strategy?
Structure of a Short Straddle
A Short Straddle is created by simultaneously selling a Call and a Put Option on an asset (such as a stock, index, currency or commodity), with the same expiry date and strike price. So, you essentially short both a Call and a Put Option at the same price.
An Option is a contract that offers an investor the privilege of buying (in case of a Call Option) or selling (in case of a Put Option) a specific quantity of an asset at a specific price (strike price) on a future date (expiry).
In this Short Straddle strategy, both the Options shorted are at-the-money (ATM) Options, i.e. the strike price for both is the same as the asset’s current market price. They are sold in exchange for a price called premium.
Objective of a Short Straddle
A Short Straddle is designed for investors who believe that an asset will not move by much in the near future. In case the price moves much in either direction, the Option buyer will benefit from it by using one of the Options. This will lead to a loss for the Option seller.
In case of a big appreciation, the Option buyer will use the Call Option to buy the asset at the original cost instead of the new, higher cost. In case of a steep depreciation, the Option buyer will use the Put Option to sell it at the original, higher price.
In both cases, the Option seller will make a loss equal to the difference between the old and the new price. However, if the price doesn’t change much, the Option buyer will use neither Option as the benefit of doing so will be less than the cost (premium) of buying the two Options. This is the scenario the Option seller is hoping for because now, he will not make a loss on either Option while earning the premium on both.
Example of a Short Straddle
Let’s understand this with the help of an example.
Let’s assume that a stock is currently trading at Rs 100 and an investor doesn’t expect it to move much over the next one month. He will initiate a Short Straddle by simultaneously shorting an ATM call and an ATM put on 100 shares of the stock, with an expiry of one month and a premium of say Rs 5 per stock or Rs 1,000 in all (two Options with 100 underlying stocks each).
Payoff when the asset appreciates
Suppose in one month, the stock rises to Rs 150. The Option buyer will use his ATM Call Option to buy it at the old price of Rs 100, earning a profit of Rs 5,000 in the process. Subtracting the premium of Rs 1000 from this, his overall profit is Rs 4,000. However, if the stock were to appreciate to only Rs 110, the Option buyer will only gain Rs 1,000. On subtracting the premium, this will become Rs 0. Thus, he will not exercise the Option. However, the Option seller will gain the premium of Rs 1,000.
Payoff when the asset depreciates
Now, imagine that the stock declines to Rs 70 after one month. In this case, using the ATM Put Option will allow the Option buyer to sell the stock at the old price of Rs 100 instead of the current price, earning a profit of Rs 3,000. Upon subtracting the premium, this becomes Rs 2,000. However, if the stock were to depreciate to only Rs 90, the Option buyer will only make Rs 1,000 by using the Option. On subtracting the premium, this will become Rs 0. However, the Option seller will earn the premium of Rs 1,000.
Risk of a Short Straddle
A Short Straddle is a highly risky strategy. It promises limited profits but innumerable losses. Therefore, it must only be used when one is absolutely convinced that the asset’s price will not change much. A significant move in either direction will incentivize the Option buyer to exercise one of the two Options and leave the Option seller with losses. Since the change in prices can be unlimited, the Option seller’s losses too can be unlimited.
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