Short Straddle: Fully Understand this Option Strategy

A short straddle is an options trading strategy that works perfectly when the expected volatility in the market is limited. You can use this strategy when you expect little movement in the price of the underlying security. However, this is a risky strategy and should be utilized carefully. 

If you want to learn about this strategy, then you are on the right platform. In this article, we are going to explain the short straddle options trading strategy. Let’s begin right away to fully understand this strategy. 

Short straddle options trading strategy definition

A short straddle options trading strategy involves selling one call option and one put option with the same expiration date and strike price. It is used in circumstances when traders firmly believe that the price of the underlying security will move sideways until the expiration date. If successful traders earn the premium received at the time of writing the options contracts. 

Explanation

A short straddle is an options trading strategy that enables traders to capitalize on the lack of price fluctuations of the underlying security. Selling both a call option and a put option of the same underlying security is to let both options expire worthless. Thus, traders earn a premium on both options as net gains. However, you should only use this strategy when you expect little or no upward or downward movement of the price. You can only make a profit when the difference between the strike price and the current price at the end of the expiration date is less than the premiums received.

Short straddle Example

Let’s try to understand this strategy with an example. Let’s suppose that a trader executes a short straddle with underlying security at a strike price of $25. Now, if the price rises to $60, the trader will face significant losses. He/she will have to sell stocks at $25 and the total loss will be stocks sold at a loss of $35 minus the premium received at the time of writing the strategy. 

Similarly, if the price drops to $15, the trader will also face significant losses. He/she will have to buy stocks at $25 and the total loss will be stocks purchased at a loss of $15 minus the premium received at the time of writing the strategy. In simple words, if the strike price plummets, the trader loses on the put option. Conversely, if the strike price increases, the trader loses on the call option. 

Breakeven

Now, what is the breakeven when using the short straddle? There are two scenarios here. The first one is upper breakeven and the second one is lower breakeven. The upper breakeven is where the strike price rises up to a limit and the total loss caused by the increase in price is offset by premiums earned. Similarly, lower breakeven is where the strike price declines up to a limit and the total loss caused by the decrease in price is offset by premiums earned.

Maximum gains

So, what is the best price level at the expiration date to make maximum gains? It is quite simple to understand. You would love to see both your call and put options go worthless. It is only possible when the current price of the underlying security is more or less similar to the strike price. As per the example taken above, traders will make maximum gains when the price stays near $25 to make both options’ contracts worthless. However, this is a very highly unlikely situation. Still, traders can make a profit if the price stays in the range to make both call and put options worthless.

The wrap-up

A short straddle is a popular option trading strategy and offers maximum gains when the price of the underlying doesn’t change significantly. However, this is a risky strategy as well. Therefore, use it when you believe that the price will not move much in either direction. Moreover, it is important to sell both call and put options of the same underlying security at the same expiration date and strike price. The main advantage of this strategy is that it is quite simple to execute. Secondly, it enables you to make gains even when the price of the underlying security doesn’t move significantly.