Short straddle
Basics of stock market
• Induction
• Bull call spread
• Bull put spread
• Call ration Back spread
• Bear call ladder
• Synthetic long & Arbitrage
• Bear put spread
• Bear call spread
• put ration back spread
• Long straddle
• Short straddle
• Max pain & PCR ratio
• Iron condor
11.1 – Context
In the previous chapter we understood that for the long straddle to be profitable, we need a set of things to work in our favor, reposting the same for your quick reference –
The volatility should be relatively low at the time of strategy execution
The volatility should increase during the holding period of the strategy
The market should make a large move – the direction of the move does not matter
The expected large move is time bound, should happen quickly – well within the expiry
Long straddles are to be set up around major events, and the outcome of these events is to be drastically different from the general market expectation.
Although it is acknowledged that the long straddle does not depend on the direction of the market, this is a very difficult bargain. Considering the five points listed, it can be difficult to make the long straddle work in your favour. Remember that the breakdown in the previous chapter was at 2%; add another 1% for desired profits, and we are essentially looking for at least a 3% movement on the index. According to my experience, it can be difficult to anticipate the market’s frequent changes. In fact, just for this reason, I pause every single time I need to start a long straddle.
I’ve seen a lot of traders carelessly set up long straddles in the mistaken belief that they are protected from the direction of the market. However, in reality, they lose money in a long straddle because of time delays and the market’s overall movement (or lack thereof). Please note that I’m not trying to convince you not to use the long straddle; nobody contests its simplicity and elegance. When all five of the aforementioned criteria are met, it functions incredibly well. The likelihood of these 5 points aligning with one another is the only problem I have with long straddle.
Consider this: A number of factors prevent the long straddle from being profitable. Therefore, as a continuation of this, the same set of factors “should” favour the “Short Straddle,” which is the opposite of a long straddle.
11.2 – The Short Straddle
Although many traders fear the short straddle (as losses are uncapped), I personally prefer trading the short straddle on certain occasions over its peer strategies. Anyway, let us quickly understand the setup of a short straddle, and how its P&L behaves across various scenarios.
Setting up a short straddle is quite straightforward – as opposed to buying the ATM Call and Put options (like in a long straddle) you just have to sell the ATM Call and Put option. Obviously, the short strategy is set up for a net credit, as when you sell the ATM options, you receive the premium in your account.
Here is an example, consider Nifty is at 7589, so this would make the 7600 strike ATM. The option premiums are as follows –
7600 CE is trading at 77
7600 PE is trading at 88
So the short straddle will require us to sell both these options and collect the net premium of 77 + 88 = 165.
Please keep in mind that the options must have the same underlying, the same expiration date, and of course, the same strike. Let’s calculate the P&L under various market expiry scenarios assuming that you have already executed this short straddle.
Situation 1: The market closes at 7200 (we lose money on the put option)
In this case, the put option’s loss is so sizable that it consumes the premium that both the CE and the PE collected, resulting in a net loss. At 7200 –
As a result of the fact that 7600 CE will expire worthlessly, we keep the premium received, meaning that 77 7600 PE will have an intrinsic value of 400. When the premium received, Rs. 88, is taken into account, we lose 400 – 88 = – 312.
312 – 77 = – 235 would be the overall loss.
As you can see, the loss in the put option equals the gain in the call option.
The market expires at 7435 in scenario two (lower breakdown)
In this instance, the strategy is in a neutral financial position.
Since 7600 CE would expire worthlessly, the premium is kept. Profit is Rs. 77 here.
Since we received Rs. 88 in premium on an intrinsic value of 165 for 7600 PE, our loss would be 165 – 88 = -77.
The loss in the put option completely cancels out the gain in the call option. Consequently, at 7435, we are in the black.
Situation 3: The market closes at 7600 (at the ATM strike, maximum profit)
The best result for a short straddle is this one. The situation is simple at 7600 because both the call and put options would expire worthlessly and the premiums from both the call and put options would be kept. The gain, in this case, would equal the net premium received, or Rs. 165.
This indicates that in a short straddle, you profit the most when the markets remain static.
The market expires at 7765 in scenario 4. (upper breakdown)
This is comparable to the second scenario we looked at. At this point, the strategy achieves parity at a point above the ATM strike.
After accounting for the premium of Rs. 77 that was received, 7600 CE would have an intrinsic value of Rs. 165, meaning that we would lose Rs. 88. (165 – 77)
7600 PE would expire worthlessly, so the premium, which is equal to Rs. 88, is kept.
We are neither making money nor losing money because the profit from the 7600 PE is offset by the loss from the 7600 CE.
This is undoubtedly the upper breakdown point.
In this case, the market is obviously much larger than the 7600 ATM threshold. Both the loss and the call option premium would increase.7600 PE will expire worthlessly, so the premium, which is equal to Rs. 88, is kept.
After accounting for the premium of Rs. 77 received, the 7600 CE will have an intrinsic value of Rs. 400 at 8000, meaning that we will lose Rs. 323. ( 400 -77)
Given that we paid Rs. 88 as the put option premium, our loss would be equal to 88 – 323 = –235.
As you can see, the call option’s loss is sizable enough to cancel out the total premiums paid.
The payoff table for various market expiries is shown below.
11.3 – Case Study (repost from previous module)
He decided to proceed with the 1140 strike because Infosys was trading close to Rs. 1142/- per share (ATM).
Here is the snapshot taken at the time the trade was started:
The 1140 CE was trading at 48/- on October 8 around 10:35 AM, and the implied volatility was 40.26 percent. The implied volatility was 48 percent and the 1140 PE was trading at 47/-. 95 dollars per lot were received in total premium.
The market anticipated that Infosys would release a respectable set of financial results. In fact, the results were better than anticipated; the specifics are as follows:
“Information Systems reported a net profit of $519 million for the July-September quarter, up from $511 million in the same period last year. The amount of revenue increased by 8.7% to $2.39 billion. Revenue increased by 6% sequentially, comfortably exceeding market expectations of growth of 4- 4.5%.
On revenues of Rs. 15,635 crores, which was up 17.2 percent from the previous year, net profit increased by 9.8 percent to Rs. 3398 crores in rupees. Economic Times is the source.
Three minutes after the market opened and around the time of the announcement, at 9:18 AM, this trader was able to close the trade.
5.4 – Effect of Greeks
Since we are dealing with ATM options, the delta of both CE and PE would be around 0.5. We could add the deltas of each option and get a sense of how the overall position deltas behave.
Given that we are short, the delta for the 7600 CE would be -0.5.
Since we are short, the delta for the 7600 PE Delta would be +0.5.
Delta added together would be -0.5 + 0.5 = 0.
The total delta shows that the tactic is neutral in terms of direction. Keep in mind that a delta-neutral straddle can be either long or short. Delta neutral suggests that the profits are uncapped for long straddles and the losses are uncapped for short straddles.
Here’s something to consider: When you start a straddle, you are undoubtedly delta neutral. But will your position still be delta neutral as the markets change? If so, why do you believe that? If the answer is no, is there a way to maintain a neutral position delta?
I can assure you that your understanding of options is far superior to that of 90% of market participants if you can structure your thinking around these ideas. You must take a small mental step forward and enter second-level thinking in order to respond to these straightforward questions.
For Visit: Click here to know the directions.