What is the Short Straddle Options strategy?

Since 1973, when Options were first traded, they garnered a reputation of being highly risky investments designed for expert traders. However, the reward that comes with the risk of investing in Options is equally high, and hence, it has always attracted money.

By definition, Options are derivatives contracts that give the buyer the right to either buy or sell a fixed amount of an underlying asset at a fixed price on or before the contract expires. This, however, is not an obligation, which means the buyer/seller can choose not to execute the order.

Options are extremely volatile, but investing can be extremely profitable if the trader has some excellent strategies to enter and exit the market at the right moment. One such strategy is — Short Straddle.

What Is a Short Straddle?

A Short Straddle is a complex Options strategy that consists of selling both a Call option and a Put option, with the same strike price and expiration date. The Short Straddle strategy is often used during volatile periods by traders when the market does not seem to move significantly higher or lower, till the date of contract expiration.

The goal is to earn the maximum possible profit. However, the disadvantage of this strategy is that there may be potentially unlimited losses. Hence, specifically highly experienced traders should use this strategy.

Understanding Short Straddles

As mentioned earlier, the Options market is extremely volatile, and thus, highly experienced traders ever use the Short Straddle options strategy to make a profit. Traders apply this strategy only if volatility can decrease before the expiration day. If the volatility is high without a particular reason, the Options may be overvalued and it should be avoided.

Short Straddle allows traders to enter the market when it lacks a proper direction and profit from the same, without having to bet on the directional momentum for a big up or down.

Traders set the goal to collect premium from the options and let both Call and Put contracts expire worthlessly. Since the chances of the underlying asset closing exactly at the strike price are often relatively less, it might leave the trader exposed to risk. However, traders can enjoy and expect profit until the difference between the asset price and the strike price is less than the premiums collected.

Example

The entire game of Short Straddle is based on prediction and determining the possible range of expected trading price of a stock on indices. To predict the range of trading price, one can simply add or subtract the price of the Call or Put option to/from the asset.

For example, if Vodafone-Idea is trading at Rs. 10 and the premium is Rs. 1, the same can be added to the asset to determine the range. Here, the upside is Rs. 11, while the downside is Rs. 9.

If the asset trades between these two ranges, the trader would lose some capital if they apply the Short Straddle strategy. However, if the price moves outside this particular range, say it hits the upper side of Rs. 12 or the lower side of Rs. 8, it allows the trader to make a good profit by overpowering the costs for both Options contracts.

What Is The Most Appropriate Time To Exercise Short Straddle?

The most appropriate time to enter the market and execute the Short Straddle is when there’s market volatility and uncertainty among the public. An investor can use this strategy when they believe that the underlying asset might not make a strong move either way.

However, if it seems that the options are overvalued, it is recommended to not trade in this strategy. It would be much better if the trader applies the strategy when the Options contract has a long expiry to account for unforeseen circumstances.

Another appropriate time to execute Short Straddle is when the value of the contract becomes greater than when the strategy was first implemented, it can counterbalance the cost that comes with the trading (transaction fees + premium paid). The result is pure profit.

Benefits And Risks Associated With Short Straddles?

No strategy is perfect and accompanies risks and rewards, and the same stands true for Short Straddle as well. The following are the advantages and disadvantages of this strategy:

Advantages of Short Straddle Options Strategy

1. Expert traders can use this strategy to make a profit from Short Straddle when there's a lack of underlying volatility in the asset's price.
2. Traders can make a clear profit when there's a possibility of a decrease in volatility.
3. The premium received and profit potential from one straddle is potentially high.

Disadvantages of Short Straddle Options Strategy

1. The profit is limited to the amount of premium collected. If the price moves too far, profits may turn into losses easily.
2. The potential risks are quite unlimited if the price moves in either direction.
3. Since both Call and Put options come with an expiration date, they cannot be held forever, i.e. they will become worthless after a point in time.

If you are planning to use the strategy, it is highly recommended that you study the market and its historical data thoroughly before investing a single rupee as the risks can be potentially higher than the rewards.