Option traders across the world create wonderful strategies by combining calls and puts in various ways. Potentially an unlimited number of strategies can be created in this way. It is very satisfying to earn profits by developing a rock solid option strategy and using it in the live market correctly.

Today let us discuss one such strategy which is called “Short Straddle”. We will see how we can earn handsome profits from the markets by using the Short Straddle strategy.

What is a Short Straddle?

Short Straddle is a strategy which is adopted by options traders who expect the markets to remain range bound. In other words, they expect the volatility of the markets to remain low in the future.

Since they do not expect huge movement in the market they sell a call option and put option with the hope that the markets will not breach a certain range of trading. Since they sell both the options they get the premiums upfront when they enter into the trade.

Remember that the short straddle is created by selling a call and a put option at the same strike price. The traders typically choose either the At The Money (ATM) strikes for executing this strategy.

For example, you can create a Short Straddle by:

l  Shorting a nifty call of strike price of 10000 and

l  Shorting nifty put of strike price 10000.

Please note that choosing the same strike price is very important as otherwise, the strategy will not work properly

What is the range within which we earn profits?

As mentioned earlier, in a Short Straddle, you can earn profit only when the markets remain range bound. This range will be dependent on how much premium you get when you short the call and the put.

Short Straddle is a net credit strategy since you receive the premium from both the legs of the transaction and do not have to pay anything upfront.

The net credit is calculated as:

Net credit = premium received by shorting the call + premium received by shorting the put

The range at which you make prophets will have two bounds (limits):

l  Upper bound = strike price + net credit

l   Lower bound = strike price minus the net credit

So let us take an example to understand this.

Suppose in the above example where we shorted the call and put at a strike price of 10000, we received Rs. 130 by selling the call and Rs. 120 by selling the put.

Hence our net credit = (130 + 120) = Rs. 250

So the range in which we make a profit works out to be:

l  Upper bound = (10000 + 250) = 10250

l  Lower bound = (10000 – 250) = 9750

We will make a profit when the market remains range bound between 9750 and 10250 as per our expectations. If the market moves above 10250 or below 9750, then we will start incurring unlimited losses.

Therefore use this Short Straddle strategy only when you are completely sure that the markets will remain neutral, i.e. Range bound between 9750 and 10250.

Profit potential:

The maximum profit that you can earn from this strategy will be the net credit, i.e. Rs. 250 in this example. Since it is an option sale strategy you can never earn more than this amount.

Loss potential:

If your view turns out to be wrong and the markets make a sharp move in either direction, you will start incurring unlimited losses. Thus, it might be very risky to execute the Short Straddle strategy when a major news is expected in the market. To execute this strategy only when markets are done and no major triggers are expected for the markets in the near future.

Margin Requirement:

Since you are selling the options, you will be subjected to the margin requirements of the exchanges. You will have to maintain the initial margin and also profile the mark to market margin to the exchange. So you need to ensure that you have adequate capital in hand to meet this margin requirement.

Payoff:

The maximum payoff from this strategy will happen if the market closes at the levels of the strike price upon expiry. This will cause both the call and report to expire what does any will get to keep the entire premium that you had received by selling both.

If the markets close anywhere within the profitable range, you will get to keep a part of the total premium that you received. Let us understand this by continuing the example that we have been discussing till now.