Table of Contents
Option Strategies – What is “The Short Straddle” ?
Those who already read our “Long Straddle” Strategy would understood that for the long straddle to be profitable, we need a set of things to work in our favor, reposting the identical for your quick reference –
The volatility should be relatively low at the time of approach execution
The volatility should increase during the conserving period of the strategy
The market should make a large go – the direction of the move does not matter
The predicted large move is time bound, should manifest quickly – well within the expiry
Long straddles are to be setup round major events, and the outcome of these events to be extensively different from the general market expectation.
Agreed that the directional movement of the market does now not matter in the long straddle, but the good deal here is quite hard. Considering the 5 points list, getting the lengthy straddle to work in you favor is quite a challenge. Do recall, in the previous chapter the breakdown used to be at 2%, add to this another 1% as desired profits and we are in reality looking for, at least a 3% move on the index. From my experience looking forward to the market to make such moves regularly is quite a challenge. In truth for this reason alone, I think twice each and each and every time I need to initiate a long straddle.
I have witnessed many merchants recklessly set up long straddles thinking they are insulated to the market’s directional movement. But in reality they quit up losing money in a long straddle – time extend and the general movement in the market (or the lack of it) works against them. Please note, I’m now not trying to discourage you from employing the long straddle, no one denies the simplicity and magnificence of a long straddle. It works extremely well when all the 5 factors above are aligned. My only issue with long straddle is the chance of these 5 points aligning with each other.
Now think about this – there are pretty a few factors which prevents the long straddle to be profitable. So as an extension of this – the same set of elements ‘should’ favor the opposite of a long straddle, i.e the ‘Short Straddle’.
The Short Straddle – there are quite a few factors which prevents the long straddle to be profitable. So as an extension of this – the equal set of factors ‘should’ favor the opposite of a lengthy straddle, i.e the ‘Short Straddle’. Although many traders fear the short straddle (as losses are uncapped), I in my opinion prefer trading the short straddle on sure occasions over its peer strategies. Anyway let us quickly understand the set up of a quick straddle, and how its P&L behaves across various scenarios.
Setup of Short Straddle
Setting up a short straddle is pretty straight forward – as opposed to buying the ATM Call and Put preferences (like in long straddle) you just have to sell the ATM Call and Put option. Obviously the quick strategy is set up for a net credit, as when you sell the ATM options, you get hold of the premium in your account. Here is an example, consider Nifty is at 15599, so this would make the 15600 strike ATM. The option premiums are as follows –
15600 CE is buying and selling at 87
15600 PE is trading at 88
So the short straddle will require us to sell each these options and collect the net top class of 87 + 88 = 175.
Please do note – the options need to belong to the same underlying, same expiry, and of course identical strike. So assuming you have executed this short straddle, let’s figure out the P&L at quite a number market expiry scenarios.
1 – Market expires at 7200 (we lose money on put option)This is a scenario where the loss in the put choice is so large that it eats away the premium collected by way of both the CE and PE, resulting in an overall loss. At 15200 –15600 CE will expire worthless, as a result we get the retain the premium received i.e 87
15600 PE will have an intrinsic fee of 400. After adjusting for the premium received i.e Rs.88, we lose four hundred – 88 = – 312
The net loss would be 312 – 87 = – 225
As you can see, the gain in name option is offset by the loss in the put option.
2 – Market expires at 15435 (lower breakdown)This is a state of affairs where the strategy neither makes money nor loses any money.
15600 CE would expire worthless; as a result the premium received is retained. Profit here is Rs.87
15600 PE would have an intrinsic price of 165, out of which we have received Rs.88 as premium, hence our loss would be 165 – 88 = -77
The achieve in the call option is completely offset by way of the loss in the put option. Hence we neither make money nor lose money at 15435.
3 – Market expires at 15600 (at the ATM strike, most profit)
This is the most favorable outcome for a short straddle. At 15600, the situation is pretty straight forward as both the call and put alternative would expire worthless and hence the premium obtained from both the call and put option will be retained.
The acquire here would be equivalent to the net top rate received i.e Rs.165. So this means, in a short straddle you make maximum cash when the markets don’t move!
4 – Market expires at 15765 (upper breakdown) This is similar to the 2nd scenario we discussed. This is a factor at which the strategy breaks even at a point higher than the ATM strike.15600 CE would have an intrinsic cost of 165, hence after adjusting for the premium received of Rs. 87, we stand to lose Rs.78 (165 – 87)
15600 PE would expire worthless, as a result the premium received i.e Rs.88 is retained
The gain made in the 15600 PE is offset in opposition to the loss on the 15600 CE, hence we neither make money nor lose money.
Clearly this is the upper breakdown point.
5 – Market expires at 16000 (we lose cash on call option)
Clearly the market in this scenario is way above the 15600 ATM mark. The call alternative premium would swell, so would the loss –15600 PE will expire worthless, hence the premium obtained i.e Rs.88 is retained
At 16000, the 15600 CE will have an intrinsic value of 400, hence after adjusting for the premium obtained of Rs. 87, we stand to lose Rs. 313( 400 -87)
We have received Rs.88 as premium for the Put option, consequently the loss would be 88- 313 = -225
So as you can see, the loss in the call option is significant sufficient to offset the combined premiums received.
Here is the payoff table at different market expiry levels.
As you can examine –The maximum profit 165 takes place at 15600, which is the ATM strike
Analyzing the results of Short Straddle
The strategy remains profitable solely between the lower and higher breakdown numbers
The losses are unlimited in both direction of the market. We can visualize these points in the payoff structure right here –From the inverted V shaped payoff graph, the following things are quite clear –The factor at which you can experience maximum profits is at ATM, the earnings shrink as you move away from the ATM mark
The strategy is worthwhile as long as the market stays within the breakdown points
Maximum loss is experienced when markets pass further away from the breakdown point. The further away the market moves from the breakdown point, greater the loss
Max loss = Unlimited
There are two breakdown points – on either side, equidistant from ATM
Upper Breakdown = ATM + Net premium
Lower Breakdown = ATM – Net premium
As you may have realized by way of now, the short straddle works exactly opposite to the lengthy straddle. Short straddle works best when markets are expected to be in a range and no longer really expected to make a large move. Many merchants fear short straddle considering the reality that short straddles have unlimited losses on either side.
Short straddle requires you to concurrently Sell the ATM Call and Put option. The options should belong to the same underlying, identical strike, and same expiry
By selling the CE and PE – the trader is setting the bet that the market wont move and would essentially remain in a range
The maximum profit is equal to the net top class paid, and it occurs at the strike at which the long straddle has been initiated
The upper breakdown is ‘strike + internet premium’. The lower breakdown is ‘strike – net premium’
The deltas in a short straddle provides up to zero
Volatility in Short Straddle?
The volatility should be relatively high at the time of approach execution
The volatility should decrease during the retaining period of the strategy
Short straddles can be set around major events, whereby before the event, the volatility would drive the premiums up and just after the announcement, the volatility would cool off, and so would the premiums.