Rooting For The Straddle Strategy

In the last issue, we delved into the intricacies of a unidirectional strategy known as the ‘long straddle’. Building on this foundation, we turn our attention to this issue to another prominent unidirectional strategy: the short straddle. The short straddle, much like its long counterpart, involves the simultaneous writing of both a call and a put option at the same strike price and expiration date. By understanding and monitoring the aspects of the straddle strategy, traders can effectively utilise them to capitalise on expected range-bound movements.[EasyDNNnews:PaidContentStart]

Rishi Raj was a small-town trader with big dreams. Having dabbled in various stock market strategies, he was always on the lookout for something new and exciting. One sunny afternoon, as he sipped his tea and scrolled through his favorite finance blog, he stumbled upon a strategy that piqued his interest: the ‘short straddle options strategy’. The concept was straightforward: sell both a call and a put option with the same strike price and expiration date. The idea was to profit from range bound price movements, betting that the stock would remain relatively stable. It sounded like the perfect strategy for someone who wasn’t sure which way the underlying would swing but believed it wouldn't swing much. Rishi’s mind raced as he recalled the countless times he had seen the market move less than he had expected.

As the days passed, Rishi’s anticipation grew. He checked the stock price multiple times a day, eager to see how his strategy would play out. In the following paragraphs, we discuss the nitty-gritty of this strategy.

Straddle Strategy
In the last issue, we delved into the intricacies of a unidirectional strategy known as the ‘long straddle’. This approach, favoured by options traders, involves purchasing both a call and a put option with the same strike price and expiration date, thereby positioning oneself to profit from significant market movements, regardless of direction. Building on this foundation, we turn our attention to this issue to another prominent unidirectional strategy: the short straddle.

The short straddle, much like its long counterpart, involves the simultaneous writing of both a call and a put option at the same strike price and expiration date. However, while the long straddle capitalises on volatility and large price swings, the short straddle is designed for a different market scenario. It thrives in stable or low-volatility environments, where the underlying asset is expected to remain within a narrow price range.

Long Straddle versus Short Straddle: Key Differences Long Straddle
▪ Objective: To profit from significant price movements in either direction.
▪ Components: Buying one call and one put option with the same strike price and expiration.
▪ Market Outlook: Anticipates high volatility and substantial price changes.
▪ Risk and Reward: Unlimited profit potential if the market moves sharply in either direction. The maximum loss is limited to the total premium paid for the options.

Short Straddle
▪ Objective: To profit from the lack of significant price movement.
▪ Components: Selling one call and one put option with the same strike price and expiration.
▪ Market Outlook: Expects low volatility and minimal price movement.
▪ Risk and Reward: Limited profit potential, capped at the total premium received from selling the options. However, the risk is theoretically unlimited if the underlying moves significantly in either direction.

Understanding these fundamental differences is crucial for options traders. The choice between long and short straddle hinges on market conditions and the trader’s outlook on volatility. In the forthcoming sections, we will explore the mechanics of the short straddle in greater detail, examining its strategic application, potential pitfalls, and ways to mitigate risks.

Short Straddle
The short straddle is an options trading strategy used by traders who believe an underlying asset will experience a predefined range-bound movement. Expecting consolidation in a narrow range from the current market price, this strategy involves selling both an ‘at the money’ (ATM) call and a put option for the same underlying asset, with the same strike price and expiry.

For example, if the stock of Reliance Industries is trading at ₹3,000, then for a short straddle, you should sell an ATM 3,000 strike call and put option of the same expiry.
▪ Call Option: Gives the right to purchase Reliance Industries at ₹3,000.
▪ Put Option: Gives the right to sell Reliance Industries at ₹3,000. This strategy profits if the underlying asset’s price remains in a narrow range. The potential profit is limited to the total premium received from the options selling, while the loss potential is theoretically unlimited.because the strategy involves selling both a call option and a put option.

Breakeven Points
Breakeven points are the price levels at which the position will neither make a profit nor a loss after accounting for the cost of the spread. The short straddle strategy has two breakeven points and it will start yielding profits if the price remains in between these breakeven points.

1. Upper Breakeven Point: Strike Price + Total Premiums Received
2. Lower Breakeven Point: Strike Price − Total Premiums Received

Example: Considering, we sold Reliance Industries 3,000 call at ₹100 and put at ₹80, then our breakeven points are:
▪ Upper Breakeven Point: 3,000 + 100 = 3,100
▪ Lower Breakeven Point: 3,000 − 80 = 2,920

This means our position will be at a loss once Reliance Industries moves beyond the upper and lower band of the breakeven point i.e. 3,100 and 2,920. If it remains between these levels until expiry, our maximum profit will be the total premium received, which is 100 + 80 = ₹180.

Drawback: The underlying asset must experience a move in a narrow range which is the breakeven point before the expiry to make the strategy profitable. If the asset remains relatively volatile and moves significantly in either direction, the strategy will result in an unlimited loss. However, in this article, we have shared insights on when to exit the strategy, which could help to restrict your losses.

Payoff Structure
The payoff for a short straddle strategy depends on the price of the underlying asset at expiry. Here’s how it works:

1. At Expiry:

If the underlying price is much higher than the strike price:
▪ The call option will be in the money, resulting in a loss.
▪ The put option will expire worthless, resulting in a profit.
▪ ▪Net Payoff: Call option loss – put option premium received.

If the underlying price is much lower than the strike price:
▪ The put option will be in the money, resulting in a loss.
▪ The call option will expire worthless, resulting in a profit.
▪ Net Payoff: Put option loss – call option premium received.

If the stock price is close to the strike price:
▪ Both the call and put options may expire worthless or have very low intrinsic value.
▪ Net Payoff: - (call option premium received + put option premium received).

Example View for executing the strategy: Expecting a consolidation in a narrow range in the index.

Assumptions:
▪ Nifty current market price is 25,000
▪ 25,000 CE price is 350
▪ 25,000 PE price is 320
▪ Considering August 29, 2024 expiry

To execute the long straddle strategy, we will choose the ATM strike 25,000 CE and PE. Considering selling both of the options, the following table and diagram will help understand the payoff:

Breakeven Points and Position Management for Long Straddle Breakeven Point Zone:
The breakeven point zone for the long straddle strategy will be between 24,330 and 25,670 levels.

Profit and Loss Scenarios:
1. Loss Zone: Once Nifty moves beyond the breakeven point zone (either above 25,350 or below 24,680), the position will incur losses. The farther Nifty moves from the breakeven points, the higher the potential loss.
2. Profit Zone: If Nifty remains within the breakeven zone (24,680 to 25,350), the position will give profits. The maximum profit occurs if Nifty closes at 25,000, where both options will expire worthless and result in the total premium received being the profit.

Position Management Exit Strategy:
Exiting near expiry will result in maximum profit and therefore you can book hold the position if Nifty remains in the breakeven zone till expiry and book profits. If the underlying breaks the breakeven zone, it is advisable to exit the position to avoid unlimited losses. This is because if the underlying witnesses a larger move, far from the breakeven zone, it can increase the premiums of the options. By carefully monitoring the Nifty levels and the breakeven zone, you can manage the short straddle position effectively to maximise profits or minimise losses.

Conclusion
The short straddle strategy involves selling both call and put options at the same strike price, expecting consolidation in a narrow range. Breakeven points are the strike price plus | minus total premiums received. Loss occurs if the underlying moves beyond the breakeven zone while profit occurs if it remains within the breakeven zone. Exiting near expiry will result in maximum profit. By understanding and monitoring these aspects, traders can effectively utilise the short straddle strategy to capitalise on expected range-bound movements.