Selling a call and a put with the same underlying security, strike price, and expiration date constitutes a short straddle. On the graph below, Point A stands in for this strike price. Credit is received and profits are made with a short straddle when the stock maintains a narrow range. A short straddle’s potential for profit is capped at the total premiums collected. When there is little movement in the stock until expiration, this strategy performs best.
If the stock pins at the strike price at expiration, the investor will receive his maximum gain, winning both the call side and the put side and keeping the entire premium from both positions. The investor will suffer if the stock does experience a significant move, though.
Profit/Loss
Maximum Gain = Net Premium Received
A short straddle strategy has an unlimited potential loss because the stock may continue to move against the trader in either direction.
Breakeven
The premium is added to our strike price to determine the breakeven on the straddle’s upside, and its subtraction from the strike price to determine the breakeven on the downside.
Top side breakeven: 100.00 + 3.50 = 103.50
Bottom side breakeven: 100.00 – 3.25 = 96.75
Example
If a trader places a short straddle order at these prices:
- Sell 1 XYZ 100 call at 3.10
- Sell 1 XYZ 100 put at 3.30
- Net credit = 6.40
The trader would keep the full Rs6.40 and make their maximum profit if the stock closed at Rs100.
If the stock rises to Rs110, the trader would lose Rs10 on the call with a Rs100 strike price, but since they made Rs6.40 on the straddle, they would only lose Rs3.60 overall.
Conclusion
This is a market-neutral strategy that functions best when there aren’t any important announcements or earnings coming up. The traders who carry out a short straddle want the stock to maintain a largely stable price over the course of the trade.
Straddles are frequently sold by traders in order to receive two premiums, which makes it necessary for the stock to move twice as far in either direction before they start to lose money. The straddle price is typically the distance from the current price that the market anticipates the stock to travel before expiration. This means that when making this kind of trade, traders must be shrewd and have good timing.
As the investor waits for both options to expire worthless, time decay works in their favor. As the position ages, the investor gains money quickly as long as the stock does not experience any abrupt movements.
It is advised to execute a trade like this with extreme caution and in small lots because it does carry an unlimited risk.
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