What is a Short Straddle?

Short Straddle: A Closer Look

Let’s understand the short straddle strategy with the help of an example.

Imagine a security is trading at Rs 589 per share. The trader expects that the price will not make any significant moves till expiry. As a result, the trader enters into a short straddle by selling the at-the-money (ATM) call and put option. So, the trader will sell the call (CE) and put option (PE) for the 590 strike price.

The 590 CE is trading at Rs 70

The 590 PE is trading at Rs 80

The net premium for the short straddle is 70 + 80 = 150.

Here’s how the trade would fare under different scenarios:

Price of Underlying Moves Significantly

In this scenario, the price of the underlying asset either increases or declines significantly. As a result, one leg of the trade will be in profit while the other will have a considerable loss.

For example, if the underlying’s price declines to Rs 540, the call option will expire worthless allowing the trader to collect the entire premium. However, the value of the put option will increase.

If the 590 PE premium increases to Rs 200 then the gains from the call option will be offset and the trade will be in a loss.

Gain from CE – Rs.70

Loss from PE – 200 - 80 = Rs 120

Net Loss = 120 - 70 = Rs 50

The trade would be in a similar situation if the price of the underlying moves considerably higher resulting in an increase in the call premium and a decline in the put premium.

Price of Underlying Moves Slightly

In a scenario when the price of the underlying moves slightly higher or lower, the losses of one leg will be offset by the gains in the other leg resulting in a breakeven.

For example, if the price of the underlying moves to Rs 610, the 590 CE premium will increase to Rs 150 while the 590 PE will expire worthless.

Loss from CE - 150 – 70 = Rs 80

Gain from PE - Rs 80

Net P/L = Breakeven

Since the trader was able to collect the premium from the put option, the loss from the call side was offset. The trade would perform similarly if the price of the underlying had declined slightly.

Price of Underlying Does Not Move

When the price of the underlying asset expires at-the-money, the trade will be profitable. This scenario is the most favourable for the short straddle as it allows the trader to pocket the premiums from both the call and put options as they expire worthless.

Gain from CE = Rs 70

Gain from PE = RS 80

Net Profit = Rs 150

Conclusion

The short straddle strategy is a directionless strategy and can help traders benefit from a lack of movement in the price of the security. However, when selling options there is a possibility of incurring significant losses. It is crucial to have stop loss orders intact in order to prevent capital erosion.