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Short Straddle - Introduction
A Short Straddle, is a neutral option trading strategy that profits when a stock stays stagnant. This is the exact opposite of a Long Straddle which profits
when the underlying stock moves strongly either to upside or downside. When you execute a Short Straddle, you are in fact selling (or "writing")
a Long Straddle to another party. In this sense, the person who bought the Straddle position that you sold, profits when the underlying stock moves
strongly in either direction, whereas conversely, you profit when the underlying stock stays stagnant. As you are "Selling" or "Writing" a position,
you make in profit the amount of money the buyer paid for the Straddle and that creates a net credit to your account. This is what we call a Credit
Spread.
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As a Long Straddle grants you unlimited profit when the underlying asset moves strongly in either direction, it also means that as a writer of a
Short Straddle, you are exposed to unlimited loss when the underlying asset fails to stay stagnant.
When To Use Short Straddle?
One should use a short straddle when one is of the opinion that an underlying stock will stay sideways until option expiration.
How To Use Short Straddle?
Establishing a short straddle simply involves the simultaneous writing (sell to open) of a call option and a put option on the underlying asset, at the same strike price and expiration date.
This establishes a short call option and a short put option. A short call option allows you to profit when the underlying asset is sideways or down and a short put option allows you to profit when the underlying asset is sideways or up.
Combine them both and you will have a short straddle which profits when the underlying asset stays stagnant or within a tight range.
If you are already holding long or short stock position, you could also create the short straddle synthetically, known as the
Synthetic Short Straddle, without closing your existing stock position.
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Example : Assuming QQQQ at $44. Sell To Open QQQQ Jan44Call, Sell To Open QQQQ Jan44Put
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Profit Potential of Short Straddle :
The Short Straddle reaches maximum profit when both short call and put options expire during expiration. This happens when the underlying asset
closes right on the strike price of both legs during expiration. However, even if the underlying stock is slightly up or down during expiration,
the option that is In The Money do not gain enough to nullify the
value on the expired option, the position still results in a net profit. This upper and lower point where the in the money option gains the exact
value of the expire option is called the Upper and Lower Breakeven point.
Profit Calculation of Short Straddle:
Max. Return = Net Credit
% Return = Net Credit ÷ [(Option Strike Price + Highest Option Bid) - Net Credit]
Following up on the above example, assuming QQQQ at $44 at expiration.
Sold the JAN 44 Call for $2.20
Sold the JAN 44 Put for $2.00
Max Profit = $2.20 + $2.00 = $4.20
% Return = $4.20 ÷ [(44 + 2.20) - $4.20] = 10% profit
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Risk / Reward of Short Straddle:
Maximum Profit: Limited
Net Credit Received
Maximum Loss: Unlimited
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Break Even Point of Short Straddle:
There are 2 break even points to a short straddle. In this case, a breakeven point is the point from which the
position will start to make a loss. One breakeven point if the underlying asset goes up (Upper Breakeven), and one breakeven
point if the underlying asset goes down (Lower Breakeven).
Upper BEP: Strike Price + Net Credit
Lower BEP: Strike Price - Net Credit
Following up on the above example,
Upper Break Even = Strike Price + Net Credit = $44.00 + $4.20 = $48.20
Lower Break Even = Strike Price - Net Credit = $44.00 - $4.20 = $39.80
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Advantages Of Short Straddle :
Able to profit when stock do not move.
An initial credit is received on the transaction so the investor does not have to put up any money to enter into the position.
Disadvantages Of Short Straddle:
There will be more commissions involved than simply writing naked call or put options.
The loss potential is unlimited. That means that you can lose as much money as the underlying stock can move.
The profit potential is limited to the net credit recieved and nothing more.
The margin requirements for this strategy are fairly high. Your broker may require you to cover both options as if they were two Naked Options, or they may require a cash value of the Option Strike Price plus the highest bid of the call or the put.
Alternate Actions for Short Straddles Before Expiration :
1. If the underlying asset is expected to fluctuate within a slightly wider range than expected, the position can be closed in favor
of a short strangle position.
2. If the underlying asset moves strongly in one direction, you should buy back the In the Money option quickly in order to
limited losses.
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