Short Straddle Option
What is a Short Straddle?
Options straddles can be split into two different configurations, a Long Straddle and a Short Straddle. We’re going to run through the Short Straddle to explain what you will need if you wanted to run this strategy.
The Short Straddle
A short straddle is a strategy where you write (sell) calls and write (sell) puts, both with the same strike price and expiration. As you can see by the payoff diagram, it is the complete opposite of the long straddle. Together, the options produce a position that hopes for a stagnant marketplace with low volatility.
This strategy allows you to profit from a market that is essentially moving sideways. With this strategy you collect two premiums from the sale of the call and put upfront, the investor builds a larger margin of error, compared to writing just a call or a put option individually. However, the risks are substantial on the downside and unlimited on the upside, should a large move occur.
SHORT STRADDLE EXAMPLE
Let’s look at an example of a short straddle. XYZ PLC stock is trading at 395. An options trader executes a short straddle by selling a 400 put at 25 and a 400 call at 19. The net credit taken to enter the trade is the maximum possible profit (44).
If XYZ PLC stock rises and is trading at say 500 on expiry, the 400 puts will expire worthless but the 400 calls expire in-the-money and have an intrinsic value of 100 thus creating a loss of 56 (100-44) The same will happen if, for example, the stock was trading at 300 but with the 400 puts having an intrinsic value of 100.
On expiration, if XYZ stock is trading close to 400, both the 400 put and the 400 call could be bought back for maybe 2 or 3 creating a profit of around 40.
Short Straddle Summary
- Sell a put with a strike price typically at the money
- Sell a call with the same strike price as the put and with the same expiry
- Anticipates decreased volatility – You think a period of calm is coming and have a neutral view
- Underlying price of the asset to not move away from the strike you have chosen
- Premiums can be very attractive
- High time decay in a neutral market
- Higher risk strategy
- Beware of high margins
- Potential losses can accumulate very quickly
- Assignment risks on both options if they are American style