Options strategies are designed to help lower the risk involved with an options trade. In addition to that, it also allows you to reduce your losses. One of the many strategies that option traders use frequently is the short straddle. Wondering what it is? Here’s what you need to know about it and how to execute it.
What is a short straddle?
The short straddle is one of the simplest options strategies that you can execute. It involves simultaneously selling a call option and a put option of an underlying asset. One of the primary requirements of a short straddle is that both the strike price and the expiry dates of the call and put options must be the same.
The goal of the short straddle strategy is to ensure that you make profits if the underlying asset’s price remains stable until expiry with little to no movement. However, if the asset’s price moves significantly either way, the strategy will not work. The short straddle strategy is the exact opposite of a long straddle.
Open Your free Demat Account in just 5 minutes!
What is the maximum profit possible with a short straddle?
The maximum profit that you can get from a short straddle is the amount of premium that you receive from the sale of both the call and put options. This would only be possible if the underlying asset’s price remains stable and doesn’t move much since it would cause both the options to expire worthless, allowing you to pocket the premiums.
What is the risk involved with the short straddle strategy?
Unlike the long straddle, the risk with the short straddle strategy is significantly higher. If the price of the underlying moves significantly on either side, the losses that you can suffer can be high.
For instance, if the underlying asset’s price rises, the maximum loss is unlimited. On the other hand, if the underlying asset’s price falls, the maximum loss is limited to the point where the price touches zero.
However, since you receive the premiums upfront, the strategy can technically cushion you from the loss to a certain extent.
The short straddle strategy - an example
Let’s take up an example to understand the strategy better. Assume that you’re interested in the stock of Infosys Limited. You think that the share price of Infosys would remain stable until expiry with no big moves expected. As a result, you choose to execute the short straddle to take advantage of such a situation if it were to take place.
Now, the present market price of Infosys Limited is Rs. 1,421. For the strategy, you choose to go with a strike price of Rs. 1,420, which would make the options At The Money (ATM). Both the call and put options have the same near-month expiry. The premium for the call option is Rs. 36.5, whereas the premium for the put option is Rs. 30.60. The minimum lot size of the options contracts of Infosys Limited is 400.
To execute the short straddle strategy, you sell one lot of call options at Rs. 36.5 per share and one lot of put options at Rs. 30.6 per share. Through this sale, you receive Rs. 26,840 [(Rs. 30.60 x 400 + Rs. 36.5 x 400)].
Now that you’ve set the strategy up, let’s take a look at what would happen if the share price stays the same, falls and rises.
Scenario 1: If the stock price stays stable at Rs. 1,420 on expiry
This is the ideal scenario for a short straddle. In this case, since the stock price hasn’t moved at all. Both the call option and the put option would expire worthless, which effectively means that you get to keep the entire premium of Rs. 26,840 that you collected initially. This would be the maximum profit that you get to experience.
Scenario 2: If the stock price rises to Rs. 1,500 on expiry
If the stock price of Infosys Limited rises to Rs. 1,520, the put option would expire worthless. However, the call option would be exercised by the option holder. This would leave you with a loss of Rs. 32,000 [(Rs. 1,500 - Rs. 1,420) * 400]. However, the initial premium that you collected while writing the options would soften the loss a little bit and leave you with just Rs. 5,160 as the net loss from the trade.
Scenario 3: If the stock price falls to Rs. 1,360 on expiry
In this case, the call option would expire worthless. However, the put option would be exercised by the option holder. This would leave you with a loss of Rs. 24,000 [(Rs. 1,420 - Rs. 1,360) * 400]. This loss, however, would be offset by the initial premium that you collected while writing the options, leaving you with a net profit of Rs. 2,840 (Rs. 26,840 - Rs. 24,000).
Conclusion
As you can see, the short straddle is a good options strategy only if the price of the underlying asset stays stable till expiry. In the case of minor price movements in either direction, the strategy does offer a bit of protection from losses. However, if the price moves heavily toward any single direction, the losses that you suffer can be hefty.
If trading in options is something that you might be interested in, visit Motilal Oswal today to open a demat accountand a trading account in your name. Without these accounts, you cannot invest in any financial markets. Once you’ve opened your very own account, you can then proceed to trade in options, commodities or even upcoming IPOs without any hassle.