A short straddle strategy has multiple legs, and a neutral strategy in which risk is unlimited and profit potential is limited. This strategy is entirely opposite to the long straddle. In long straddles, the trader takes advantage of the high volatility, while on the other hand, in short straddle strategy, a trader can experience profit when the volatility drops, time decays, and there is no change in the price of the underlying asset.
In short straddles, traders sell short-call and short-put options with the same expiry data and strike price. Traders can earn a profit if there is no movement in the underlying asset, no effect of time decay, and no Volatility.
Short straddle from a market perspective:
Short straddles are market-neutral strategies and do not have any directional bias. A very minimal or no price movement is required to profit from this strategy. Profit is received when the position is still open, but there is a risk in either direction of the price movement.
Setting up a short straddle:
A short straddle consists of selling a short call and short put options having the same strike price and expiry. The -short straddles are sold at-the-money, though they can also be sold at a higher price or lower price to create a bullish or bearish market bias.
Suppose the stock is currently traded at Rs. 95, then a short straddle can be sold at Rs. 100. This will create a bullish market because the underlying asset's price must rise before expiry; only then there will be some profit.
The amount received by selling both the short-call and short-put options is the maximum profit from that trade, while the risk is unlimited.
Understanding the Diagram of short Straddle:
The short straddle diagram looks like an upside-down 'V' alphabet. The highest profit earned by the trader is the only amount received by selling the options contract. The highest risk is not defined. It can go beyond the profit made.
You can exit from the trade anytime you want before the contract expiry and buy short options. If the cost of purchasing the short options is less than the amount received, the trader may get a good profit.
Imagine you sold the underlying asset at Rs. 100 per share and then bought the same shares at Rs. 85 per share; then Rs. 15 per share is your profit.
Implied volatility has a direct impact on the underlying asset option price. With the fall in volatility, the price of the option contract also falls. This is a favourable condition for the options seller.
How can I enter a short straddle:
In order to enter into the short straddle strategy trader needs to sell-to-open a short call and put at the same time with the same strike price and expiry date. Suppose the stock is traded at Rs. 100, then the trader may sell call and put options at Rs. 100.
Sell-to-open: Rs,100 call option contracts
Sell-to-open: Rs. 100 put option contracts
If there is high volatility, then it will increase the price of the option. If the duration of the expiry of the contract is more than also the cost will rise. The premium collected in this case will be high.
How can I exit from the short straddle:
In this strategy, three factors can help you make a profit upon exiting. They are time decay (theta), no or minimum price fluctuations and low volatility; a combination of two or three can result in profit. You can see one option contract will be in-the-money during expiry, so it should be taken care of early to avoid the risk.
The short straddle position can be closed by applying buy to close order before expiry. Purchasing the options contract on a low amount then they were sold to can be considered as the profit.
Impact of time decay on short straddle strategy:
The time decay factor is in favour of this strategy. With every passing day, the theta reduces, and thus, there is no or smaller movement in the price of the options contract. By this, the value of the contract will be reduced. This downfall in the value will attract the buyers to buy the options contract at a lesser price compared to the one they were sold.
Impact of Implied Volatility on short straddle:
Traders benefit from the short straddle strategy if the implied volatility is low. The lower the volatility lower will be the price of the options premium. Usually, when you see the short straddle happening in the price movement, the implied volatility will be high at the beginning and decrease gradually by the time it expires. The vega (future volatility) cannot be predicted, but it will help you if you know its impact on your position.
How can I make adjustments to the short straddle?
We can make some adjustments in the short straddle till we have some time left in the expiry of that options contract. Traders can roll the spreads in any direction, either up or down, depending upon the price movement. Suppose one of the options straddles deep-in-the-money during the expiry; traders have two choices to get the profit.
Traders may close the complete position and enter again with another expiry date. When you adjust the short straddle, you gain more profit, your potential to make profit increase and also, and the risk decreases. It allows the break-even point to widen. Make sure that while making adjustments in short straddles, the contract size (lot size) should be kept the same. Only then your risk will be justified.
Suppose one side of the straddle seems challenging; then try to roll the opposite side towards the price movement to gain additional credit. It minimizes the overall risk attached, but the loss on both sides is not yet defined.
As we have seen, the short straddles have the same strike price as they are being traded, so when you adjust any one of the short options, it turns or makes an inverted position. This position means the short call options price is lower than the short put options price. Thus the gap between both options will be minimal, and traders can buy the options again and can enter into the trade one more time. This way, traders can make money.
Let us understand via an example:
A short straddle has a current price of Rs. 100 and gains a premium of Rs. 10 while entering the trade. Now, if the price rises, then the short put can be rolled to Rs. 105; this will create the Rs. 5 Inversion.
Buy to close: Rs. 100 put options contract
Sell to open: Rs. 105 put options contract
Let us assume that while making adjustments, traders incurred the cost of Rupee 1 extra; then the max profit is up to Rs. 600 if the trade closes between Rs. 100 and Rs. 105, as the stock cannot be purchased at less than Rs. 5.
How can I roll a short straddle:
You can roll the short straddle till the duration of the trade. As the time decay factor is in your favour, it will benefit you. Suppose you find the position not fruitful during the expiration, then you may close the position and reopen it for some future date. By doing so, your profit zone will get broader.
For example: If the short straddle has the current market price at Rs. 100 expiring in July, which has gained Rs. 10 as a premium, then the traders may choose buy-to-close both call and put options and re-enter the market via new sell-to-open orders in August. If rolling in this way costs additional Rs. 2, then the new break-even points would be Rs. 88 and Rs. 112.
How can I hedge the short straddle?
To hedge the short straddle means to measure the risk of the trade in case of the price of the underlying asset moves beyond the profit zone. In order to protect the trade from making more losses, traders can buy a long position and increase the spread in any one or both directions.
For example: If the short straddle has a current price of Rs.100, and the position is very challenging, then buying a long call option with a strike price of Rs. 110 is a wise idea to limit the upside risk. If the short straddle has already gained the premium of Rs.10 while entering the trade, and if the long call costs an additional Rs. 5, the new break-even points would narrow the spread to Rs. 95 and Rs. 105. In this case, the max profit is limited to Rs 500, and the highest loss is above the long call options, defined by the spread width of the options (deduct your gains). However, if the stock goes down, the highest loss or risk is yet to be defined, which will be below the short put.
Buy-to-open: Rs. 110 call option contract.
Now, if the situation is opposite to this, imagine the price of the underlying asset falling; then, in this case, buying a long put with the strike price of Rs. 90 would be a wise choice to define the risk if it continues to fall further. If purchasing the long put option costs the traders an additional Rs.5, then the profit potential will be reduced, and the max loss will equal the spread width of the put options contract (deduct the gains). The maximum loss is yet to be defined, and that would be above the short strike price if the price movement goes in the reverse direction.
Buy-to-open: Rs. 90 put options contract.
We hope this article was helpful in understanding how short straddles work. If you do ave any questions or need further help, please do not feel shy to talk to one of our experts.