What is a short straddle?

Can you make profits in a neutral market? You can, with a short straddle. A short straddle is an investment strategy where, you sell (short) a call and put option of the same underlying security, at the same expiration date and same strike price too. Now, on a cursory look, this seems counter-intuitive, right? Why would an investor sell both a call and option at the same strike price?

Here’s the key-an investor enters into a short straddle strategy when he expects the price movement to be minimal. The aim is to see that both the options expire worthless. The profit here is the premiums received. The investor is in this for the net credit, or the two premiums he expects to collect from selling both a call and put option. Essentially, a short straddle is a consensus of the options market on how limited the price moment is going to be.

What is a short straddle option? Let us see an example.

Example: Short Straddle

Stock ABC is trading at 600. The strike price is 600. This is the premium pricing in the market:

ABC 600 CE (Call option) is trading at 70

ABC 600 PE (Put option) is trading at 80.

Maximum potential profit and loss

According to the short straddle strategy, the maximum benefit you stand to earn is the total premium of 150 (70+80), provided the underlying stocks trade in the narrow range. There are two breakeven points, between which the stock price should move, in order for the short straddle to stay profitable. The potential loss on the upside and downside are both unlimited. This is because the stock price can rise indefinitely and collapse to zero.

The range of profitability

First breakeven point:

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

Second breakeven point:

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

The straddle strategy remains profitable between these two breakeven points

Let us suppose you sold both, ABC600 CE (Call option) and ABC600 PE (put option), and netted premium payment of 150. Let us discuss the various Profit and Loss scenarios here

  1. A) Assume, on the date of expiration ABC’s stock closes at 400.
  1. The ABC600 CE call option would go unexercised. So you get to retain net premium of 70.
  1. The put option, ABC600 PE, would have an intrinsic value of 200 now (for which the buyer of the option will exercise the put option). So your net loss here would be the intrinsic value minus the premium you get to keep (-200+80): -120.

iii. So your overall loss is (-120+70): -50.

In this situation, the losses due to the put option are higher than potential gains.

  1. B) ABC stock closes at 450.

Here you will neither make money nor lose money.

  1. i) The call option would expire worthless here since the predetermined strike price is higher than the current price. Here you pocket the net premium of 70.
  2. ii) The intrinsic value (worth of the option when exercised by the buyer) of the put option is 150. Your net loss is intrinsic value without the premium which you retain (-150+80):  -70.

So the net gain from the call option is equal to the loss from the put option.

  1. C) The ABC stock price closes at 600.

This is an ideal result since here the trader can make the maximum profit of 150 (sum of both the premiums of ABC 600 call option and put option). Here both the contracts would expire worthless since the strike price is the same as the closing market price, and the total premium paid at the time of selling both the put and call will be retained.

  1. D) The ABC stock price closes at 800.

Here also, the result would be similar to scenario A, where losses from the call option would far exceed the gains from the put option or even the sum of the two premiums you earned from selling the call and put.

  1. The ABC600 PE (put option) would go unexercised. So you get to retain net premium of 80.
  2. The call option, ABC600 CE, would have an intrinsic value of 200 now (for which the option buyer will exercise the call option.) So your net loss here would be the intrinsic value minus the premium you get to keep (-200+70): -130.

iii. So your overall loss is (-130+80): -50.

In this situation, the losses due to the call option exceed the net premium you received from selling both the options.

Scenario A and D show us the risk- that the losses on both sides are unlimited here.

  1. F)  ABC stock closes at 750

Again, this is a no-profit-no-loss situation.

  1. i) The put option would expire worthless because the strike price is lower than the market price of stock ABC. So here the gain is the premium received for selling ABC600 put option which is 80.
  2. ii) Here the intrinsic value of the call option is 150. The call would be exercised. Your net loss, in this case, would be the intrinsic value minus the premium you received. Net loss is (-150+70): -80.

The net gain from the put option offset the net loss from the call option.

Stock Price (Strike Price is 600) Value of Short Call At Expiration Value of Short Put at expiration Short Straddle Profit/Loss at expiration
800 -130(loss of intrinsic value of 200 minus premium retained of 70) 80 (premium on PE as the option expires worthless) -50
750 -80 (loss of intrinsic value of 150 minus pocketed  premium of 70) 80 (premium on PE as option goes unexercised) 0
600 70(premium on CE) 80 (premium on PE) 150
450 70 (premium on CE, as option goes unexercised) -70 0
400 70 (premium on CE, as option goes unexercised) -120 -50

When does the strategy work?

Having studied the scenarios above, it is clear that this strategy works in times of ‘low volatility’ or minimum movement in stock prices. The volatility can be just high enough for the stock prices to move in the range between the breakeven points. Straddle prices are indicative of the opinion of the options market on how widely the stock prices are expected to swing by the time the options expire. You would find short straddle strategies working around the time there is a lull in the market, usually between two news announcements or earnings release or when there are no mainly marketing moving triggers.

Yet another factor that works in favour of the strategy is time decay. Each day that passes with steady stock prices works favourably for the pricing of the straddle.

Conclusion:

In a nutshell, short straddles are recommended for seasoned investors to take advantage of low implied volatility, and to shore up two upfront premiums in times of limited price movement. The upside risk is unlimited in case of short straddles, if stock prices begin to rise exponentially, and there is also significant downside risk if stock prices fall fast, as they can fall right up to zero. But as long as stock prices are expected to move within the band of two breakeven prices, there is scope to make profits from premium receipt.