A Short Straddle is a systematic option strategy that sells both Call and Put options at the same strike price and expiration date. During volatile periods, when the market does not move significantly higher or lower until the expiration of contracts, Short Straddles are used by traders.
The objective is to maximise the profit potential. However, the disadvantage of this strategy is that it can lead to potentially unlimited losses. This strategy should be used by a specific group of traders with high professional experience. Read this article below to learn more about the what are options trading short straddle strategy.
Understanding Short Straddle Strategy
As already mentioned, the options market has a very volatile character, and therefore, highly experienced traders often use short straddle strategies to profit from it. This strategy is used by traders only if volatility can drop before the expiration day. The option may be overvalued and should not be avoided if volatility is high.
Short straddle trading enables traders to profit from a market that lacks a clear direction without having to make predictions on the direction of the market’s momentum for a significant up or down move.
Traders intend to profit from the option premium while permitting the Call and Put contracts to expire unpaid. The trader can be at risk in this scenario since there are frequently substantially fewer possibilities that an asset could close at its strike price. However, traders get a profit and anticipate making money if the spread between the asset and strike prices is less than the premiums paid.
Appropriate Time To Exercise Short Straddle Strategy
When there is market volatility and uncertainty among the public, it is the most appropriate time to enter the market and implement the Short Straddle strategy. If an investor feels that the underlying asset will not be able to make a decisive move either way, Then the trader can take advantage of this strategy.
However, it is recommended not to take part in this strategy if the options appear to be overvalued. If the options contract had an extended expiry because of unexpected circumstances, it would have been much more advantageous for the trader to use a strategy.
When the contract’s value rises above its initial value, this can help balance the cost of trading (transaction fees plus premium paid), which is another acceptable opportunity to execute a short straddle. There is a complete profit as a result.
Benefits Of Short Straddle Strategy
The advantages of the short straddle strategy are explained below.
- Professional traders can use this strategy to profit from the short Straddle if there are no fundamental fluctuations in asset prices.
- If there is a chance of falling volatility, traders should profit handsomely.
- There is a potential for high premiums received and profit potential from one straddle.
Risk Associated With Short Straddle Strategy
The risk involved with the short straddle strategy is as follows.
- The profit will be restricted to the amount of premiums collected.
- The profit may turn into losses quickly when the price rises too high.
- The potential risks are unlimited if the price moves one way or another.
- Since both Call and Put options expire simultaneously, they can’t be held forever, meaning they’ll be worthless at some point.
Example Of Short Straddle Strategy
Scenario: In the short term, you believe that the exchange rate of the Indian Rupee INR against the US Dollar USD will remain relatively stable. You want to benefit from that stability, and the exchange rate for USD is 75 INR. You’re going to go with a short straddle strategy.
- Determine the current exchange rate and the strike price:
In this example, the current exchange rate is 75 INR per USD. You can choose a strike price of 75 INR per USD for both calls and put options.
- Choose the options:
You’re selling both a call option and a put option with the following specifications:
- The strike price shall be 75 Indian rupees for each US dollar.
- The expiration date is 1 month from today.
- 2 INR per USD Put Option: The strike price will be INR 75 to USD.
- The expiry date is 1 month from today. Premium Received: INR 2 per USD
- Calculate the total premium received:
You will receive a premium of INR 2 per USD for the sale of both call and put options. You will be awarded an overall premium of 2,000 INR because each option contract is 1,000 USD on the foreign exchange options market.
- Profit loss scenarios:
If the exchange rate remains at 75 INR per USD or is close to it at the end of the period, The options for both calls and puts expire worthless. You’ll keep the entire premium of 2,000 INR for profit.
If the exchange rate is much lower than 75 INR per USD:
One option, a call or put, can be exercised and may result in potential losses. Your losses are unlimited on the upside (call option) and limited by the strike price minus premium on the downside (put option). Your maximum potential loss is the difference between the strike price and the premium received, which is 73 INR per USD (75 INR – 2 INR).
- Risk Management:
If the exchange rate makes a significant move to mitigate risk, you could consider establishing a Stop loss order or applying additional risk mitigation strategies to limit possible losses.
A short straddle, which is to say that both a put option and a call option are traded with the same expiry date and strike price, can be described as a sell straddle strategy. This strategy enables investors to profit if they accurately predict that the market will show no upward or downward movement. Choose a share market app like Share India for safe and secure option trading.