Question

Explain how to build a Short Straddle, what are the purposes of a Short Straddle strategy? Build a real life Straddle for a stock of your choice, pull the options contracts and paste them on the answer. Please explain each part of it, what the credit or debit will be for the transaction, include every detail of each option contract you will use to build the Straddle trade.

Answer 1

Short straddle is a most important way in which traders can combine options and shape the risk and return characteristics.

Straddle consists of a call and a put with the same expiration and same exercise price. The buyer of a straddle buys the call and put, while the seller of a straddle sells the same two options. The profit anf losses for buying the straddle are the combined profits and losses from buying both options.

Assume,

Expiration date of the option be T

Present date be t

Current price of the option be Ct

Price of the option at expiration CT

Present price of the put be Pt

Price of the put at expiration be PT

Using the above, the cost of long straddle is Ct + Pt

Value of the straddle at expiration will be CT + PT = MAX { 0, ST - X } + MAX { 0, X - ST }

Short straddle position costs - Ct - Pt

The value of short straddle at expiration

- CT - PT = - MAX { 0, ST - X } - MAX { 0, X - ST }

Short straddle is a neutral position as the most of the time a short straddle trader will sell the at the money options. Combining the sale of an at the money call is a bearish and selling a put is a bullish results in a neutral position.

Short straddle realises maximum profit when stock price is trading at short strike at expiration.

Example - If sock price is not showing any signs of breaking out, sell a call and a put of the same strike price and expiry date. There will be a profit of the stock doesnot show a big movement before expiry.

Let XYZ 0.05 % is trading at INR 301

Trade - sell INR 300 call for INR 7 and INR 300 put for INR 4.60

Received - 7+ 4.6=11.60 × lot size of 1000 shares = INR 11600

HE seller will still gain if the stock does not rise beyond INR 311.60 or falls below INR 289.40 by expiry. The buyer will lose if the movement is bigger.

The maximum profit for the short straddle trader occurs when the stock price at expiration equals the exercise price.

If the stock price is eual the exercise price, the straddle owner cannot exercise either the call or the put profitably. Both options expire worthless and the short straddle trader keeps both option premiums for a profit.

If stock prices diverges from the exercise price, the long straddle holder will exercise either the call or the put. The short trader essentially bets that the stock price will not be too volatile. In making this bet, the straddle seller risks theoretically unlimited losses if the stock price goes too high.

The short trader losses are unlimited if the stock price goes too low. The short trader cash inflows equal the sum of tht two option prices. At expiration, the short trader's cash outflow equals the exercise result for the call anand for the put.