Short Straddle Options Trading Strategy with examples

Context

The previous chapter elucidated that the long straddle must have certain components in order to be effective. To recapitulate, these components are:

1. The volatility should be relatively low at the time of strategy execution
2. The volatility should increase during the holding period of the strategy
3. The market should make a large move – the direction of the move does not matter
4. The expected large move is time bound, should happen quickly – well within the expiry
5. Long straddles should be placed around major events which yield significantly different results than the market anticipated.

It is accepted that the general direction of the market is irrelevant for the long straddle, however it is difficult to get it working for you. When taking into account our 5-point outline, it becomes even tougher. Going back to the previous chapter, we worked out a 2% drop as breakdown. To make a substantial profit, an additional 1% needs to be gained. This means we are after at least a 3% shift in index value. This being said, I hesitate every time I need to set up a long straddle due to how demanding it can be to get such movements repeatedly.

I have seen many traders mindlessly put on long straddles when they mistakenly believe they are protected from the changes in the market. In truth, however, these strategies typically end in losses caused by latent timing issues or a lack of trends in the market. I don’t wish to discourage you from using them, because it is undeniable that a long straddle can be effective when all five components function together perfectly. The issue lies with the probability that each of those five aspects will fit into place.

Now take this into account – there are several factors that can make a long straddle unprofitable. Therefore, these same factors should benefit the short straddle – its opposite.

– The Short Straddle

I personally prefer trading the short straddle to its other strategies in certain cases, despite traders’ fear of the risk of uncapped losses. Let us take a look at how this strategy works and examine how its profit and loss varies in different scenarios.

The short straddle is relatively simple to set up. Rather than buying the ATM Call and Put options as in a long straddle, you simply need to sell them. This creates an overall credit effect, as you gain premium deposited into your account.

This illustration offers an example of Nifty at 7589, where the option with a 7600 strike rate is ATM. The premiums for this option are as follows –

• 7600 CE is trading at 77

• 7600 PE is trading at 88

So the short straddle will require us to sell both these options and collect the net premium of 77 + 88 = 165.

Note that these options need to be of the same underlying, expiry, and strike. With this short straddle having been executed, let’s calculate the P&L for various market expiry scenarios.

Scenario 1 – Market expires at 7200 (we lose money on put option)

In this situation, the losses incurred on the put option are so substantial that they end up cancelling out the gains achieved from both call options. As the index is at 7200 –

• 7600 CE will expire worthless; hence we get the retain the premium received i.e 77

• 7600 PE will have an intrinsic value of 400. After adjusting for the premium received i.e Rs.88, we lose 400 – 88 = – 312

• The net loss would be 312 – 77 = – 235

As you can see, the gain in call option is offset by the loss in the put option.

Scenario 2 – Market expires at 7435 (lower breakdown)

This is a situation where the strategy neither makes money nor loses any money.

• 7600 CE would expire worthless; hence the premium received is retained. Profit here is Rs.77

• 7600 PE would have an intrinsic value of 165, out of which we have received Rs.88 as premium, hence our loss would be 165 – 88 = -77

• The gain in the call option is completely offset by the loss in the put option. Hence we neither make money nor lose money at 7435.

Scenario 3 – Market expires at 7600 (at the ATM strike, maximum profit)

This is the most desirable result of a short straddle. When the underlying stock price reaches 7600, both the call and put options would be worthless, so the premium collected from them would remain with investor. This would translate as a gain of Rs. 165, which is equivalent to the net premium received.

So this means, in a short straddle you make maximum money when the markets don’t move!

Scenario 4 – Market expires at 7765 (upper breakdown)

This analogous to the second proposed scenario. The strategy yields a break-even rate higher than the ATM strike.

• 7600 CE would have an intrinsic value of 165, hence after adjusting for the premium received of Rs. 77, we stand to lose Rs.88 (165 – 77)

• 7600 PE would expire worthless, hence the premium received i.e Rs.88 is retained

• The gain made in the 7600 PE is offset against the loss on the 7600 CE, hence we neither make money nor lose money.

Clearly this is the upper breakdown point.

Scenario 5 – Market expires at 8000 (we lose money on call option)

The market in this case is much higher than the 7600 ATM mark. This means that the call option premium would be significantly increased, as would the loss.

• 7600 PE will expire worthless, hence the premium received i.e Rs.88 is retained

• At 8000, the 7600 CE will have an intrinsic value of 400, hence after adjusting for the premium received of Rs. 77, we stand to lose Rs. 323( 400 -77)

• We have received Rs.88 as premium for the Put option, therefore the loss would be 88- 323 = -235

So as you can see, the loss in the call option is significant enough to offset the combined premiums received.

As you can observe –

1. The maximum profit 165 occurs at 7600, which is the ATM strike
2. The strategy remains profitable only between the lower and higher breakdown numbers
3. The losses are unlimited in either direction of the market

We can visualize these points in the payoff structure here –

From the inverted V shaped payoff graph, the following things are quite clear –

1. Reaching ATM will give you the highest possible profits, but diminishing returns occur as you deviate from that point.
2. It is only profitable as long as the market remains between the pre-defined boundaries.
3. As the markets stray farther away from the breakdown point, the amount of loss increases dramatically. The extent of damage is directly proportional to the distance travelled.
   1. Max loss = Unlimited
4. There are two breakdown points – on either side, equidistant from ATM
   1. Upper Breakdown = ATM + Net premium
   2. Lower Breakdown = ATM – Net premium

As you may have realised, the short straddle is the antithesis of the long straddle. It works best in markets predicted to remain confined within a certain range, rather than make a substantial move.

Many traders are wary of the short straddle due to its potential for unlimited losses on either side. However, based on my experience, this strategy can be extremely effective when executed correctly. To demonstrate, I featured a case study involving a short straddle in the last chapter of the previous module: likely one of the clearest examples of how to use it.

I am posting the case study again in hopes that you’ll gain a deeper understanding.

– The Greeks

We can understand how the overall position deltas behave by adding the deltas of both CE and PE, which would be around 0.5 each.

• 7600 CE Delta @ 0.5, since we are short, the delta would be -0.5

• 7600 PE Delta @ – 0.5, since we are short, the delta would be + 0.5

• Combined delta would be -0.5 + 0.5 = 0

The delta combined result shows that the strategy is directionless, with neither a long or short preference. A long straddle will gain profit without an upper limit, while a short straddle can lead to unlimited losses.