What is Short Straddle?

What's a short straddle, anyway?

Are you able to make profits in neutral markets? A short straddle is a way to make profits in a neutral market. A short straddle allows you to sell (shorten) both a call option and a put option of the same security at the same expiration and strike price. This seems counterintuitive at first glance. An investor might sell both a call or an option at the same strike price.

The key is that an investor will enter a short-straddle strategy if he anticipates that the price movement will be minimal. Both options should be deemed worthless. Here, the profit is the premiums earned. Investors are in this to make the net credit or the premiums they expect to receive from selling both a put and call option. A short straddle, in essence, is an agreement of options traders on the price moment.

What is a short-straddle option? Let's take an example.

Short Straddle

Stock ABC trades at 600. 600 is the strike price. This is the premium pricing on the market.

ABC 600 CE (Call Option) trades at 70

ABC 600 PE (Put Option) trades at 80

Maximum profit and loss

The short straddle strategy allows you to gain maximum benefits of up to 150 (70+80) if the underlying stocks are trading within a narrow range. The stock price must move between these two breakseven points in order for the short-straddle to be profitable. Both the upside- and downside risks are unlimited. Because the stock price can fluctuate between zero and an indefinitely rising high, it is possible to lose all of your capital.

The range for profitability

First breakeven point

600+150=750 (strike price+total premium)

Second breakeven point

600-150=450 (strike price-total premium)

Between these two breakeven points, the straddle strategy is still profitable

Assume you sold bothABC600CE (Call option), and ABC600PE (put option), and received a premium payment of 150. We will discuss the different Profit and Loss scenarios.

1. Assume that, on the date for expiration, ABC's stock closes in at 400.

1. The ABC600 CE call option will not be exercised. You will retain a net premium of 70.

1. The intrinsic value of ABC600 PE would be 200 right now. This is the price at which the buyer will exercise the option. Your net loss would be the intrinsic price minus the premium that you keep (-200+80), which is -120.

iii. Your total loss is (-120+70), iii.

This situation is where the potential losses from the put option outweigh the gains.

1. Stock closes at 450

You will not make or lose any money here.

1. i) The call option will expire without value here, since the strike price has been predetermined higher than the current price. This will allow you to pocket the net premium 70.
2. iii) The intrinsic worth (worth of the option when exercised) of the put option at 150 is 150. Your net loss is the intrinsic value of the option without any premium you retain (-150+80).

The net gain from the option call is equal to that of the option put.

1. C: The closing price of ABC stock is 600.

This is a great result as the trader can make a maximum of 150 profit (sum of both premiums for the ABC 600 call option or put option). Both contracts would be worthless as the strike price will equal the closing market price. The premium paid at the time you sold the call and put will also be retained.

1. D The ABC stock price closes below 800

This scenario would also be identical to scenario A. Here, losses from the call option would be far greater than gains from the option, or even the sum total of the premiums earned by selling the call and the put.

1. The ABC600 PE (put options) would not be exercised. You will still be able to keep the net premium of 80.
2. The intrinsic value for the ABC600 CE call option would be 200 (for which the option buyer will choose to exercise the call option). Your net loss would be the intrinsic price minus the premium that you keep (-200+70), which is -130.

iii. Your total loss is therefore (-130+80), -50.

This situation means that the loss from the call option is greater than the premium you earned by selling both options.

Scenario A & D illustrate the risk that both parties can lose unlimited amounts.

1. F] ABC stock closes at 775

This is a win-win situation.

1. i) The put options would be worthless as the strike price is less than stock ABC's market price. The premium for selling ABC600 puts option is 80.
2. iii) The intrinsic value of this call option is 150. You would exercise the call. In this instance, your net loss would be the intrinsic value less the premium you received. Net loss is (-150+70), -80.

The net gain of the put option was greater than the net loss of the call option.

How does this strategy work?

These scenarios show that the strategy is effective in low volatility or minimal stock price movement. Stock prices can move within the range of the breakeven point if the volatility is high enough. The options market's opinion on the expected swing of stock prices by the expiration of options is reflected in straddle prices. Short straddle strategies would work when the market is quiet, typically between two earnings releases or news announcements.

Time decay is another advantage to the strategy. Time decay is a positive factor in the pricing of the straddle.

Conclusion

Short straddles can be used by seasoned investors to benefit from low implied volatility and to protect two upfront premiums during periods of price movements that are not as extreme. Short straddles have unlimited upside potential if stock price rises rapidly. Stock prices can also fall quickly, which could lead to a loss of all capital. Premium receipts can be profitable as long as stock price movements are within the range of two breakeven points.