What is a Short Straddle? - Know When to Use it | Espresso

Short Straddle-Here's all you need to know

Volatility refers to fluctuations and variations in stock prices. Its measurement is based on statistical tools like variance, standard deviation, and beta. During the short and medium terms, these variations are significant. They augment the probability of loss, and therefore, impart risk.

Published on 22 March 2022

Several factors influencing market movements result in variations. But, with the help of a combination of call and put options, an investor can benefit from volatility. This strategy is known as a straddle.

There are two types of straddles - long and short. A long straddle is beneficial when extreme volatility is expected in the market in the near term. A short straddle is useful when there is an expectation of limited volatility in the near term.

What is a Short Straddle?

The short straddle strategy involves a short call, and a short put bought with the same underlying asset, strike price, and expiration date. It is used during minimum volatility in the market. Here, the trader does not predict any market movement and expects to earn a profit without any change in stock prices.

Short Straddle Example

Suppose NIFTY is at 8500 points. Then, if an investor anticipates low volatility and desires to earn a profit from this volatile market condition, the short straddle strategy is ideal for use.

As part of the strategy, the trader sells both a put and call option at 8500. They are both at-the-money options. For this example, we take a lot size of 75. The premium earned on the sale of the call is ₹70, and on selling the put option, the trader earns a premium of ₹80.

The profit earned after receiving the premiums is the total premium. The total premium received is the maximum profit (₹70 + ₹80) X 75 = ₹11,250.

  • Case 1

If NIFTY closes at 8500, it means there is no change in the price. The trader earns a maximum profit of ₹11,250 as the call and put options expire worthless.

  • Case 2

If NIFTY closes at 8100, it is indicative of a significant spike in the price. As a result, the call option will expire. The trader will receive a premium of ₹70 and exercise the put option. The total loss will amount to ₹320 (8500 - 8100 - 80).

  • Case 3

In this scenario, let us assume NIFTY closes at 8860. It is more than the current price. So, the put option will expire, and the premium received is ₹80. Now, the trader will exercise the call option, resulting in a total loss of ₹290 (8860 - 8500 - 70). But, this loss is compensated by the profit earned from the put option.

When a trader can compensate for the loss with the profit, it is known as the breakeven point.

When is the Strategy Effective?

After studying the different short straddle examples shared above, it is evident that the strategy is effective during low market volatility or minimum movement in stock prices. The volatility level must be adequate for the stock prices to go up or down in the range between the breakeven points.
Also Read: Volatility Index & its Equity Impact

Summing Up

To conclude, short straddles are suited for seasoned investors. It allows them to use low implied volatility to their advantage. Besides, traders can shore up two upfront premiums during limited price movement. If stock prices are on an exponential rise, the upside risk is unlimited.

Conversely, during a fall in stock prices, there is significant downside risk as their prices can fall right up to zero. It is a lot more complex than the long straddle strategy, and therefore, investors must identify their expertise to decide which straddle strategies are right for them.
Also Read: What is Short Call Strategy in Option Trading?

Chandresh Khona
Team Espresso

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