Why Short Straddles is A Good Strategy in Options Trading?
Overview of Straddle Strategy
Options trading provides a whole myriad of strategies for all types of market conditions, whether the market is going up or down or even if the market is not going anywhere. One of the innovative strategies that option traders devised was the straddle. One of the main reasons straddles became a staple strategy among traders is the rise of volatility in today's market conditions.
A holder of a long straddle buys both a call option and a put option at the same strike price for the same expiration month. The trader essentially is both long and short the option's underlying asset, thereby transforming the combined option strategy into a volatility play. You don't have to predict the market direction because you can make money regardless of whether it moves up or down. The trader needs the market price to move higher or lower so that the profit goes beyond the premium cost of buying the call and put. Long-straddle traders look for impending events, news, corporate announcements, or any developments that will cause an explosive move in the underlying prices, regardless of direction.
This article, however, will explore the short straddle, which takes the opposite side of the long straddle, and why this can be a good strategy.
How To Implement the Short Straddle Strategy
A short straddle involves selling both a call and a put with the same strike price and expiration month. Traders use the short staddle when they believe that the underlying market will be relatively stable or trading in a range around the strike price.
Consider an example using the FTSE Bursa Malaysia KLCI Options (OKLI), an option on the FTSE Bursa Malaysia Kuala Lumpur Composite Index Futures(FKLI) traded on Bursa Malaysia Derivatives Berhad.
Assumptions:
Underlying asset: FKLI
Current FKLI price: 1,600
Options: OKLI
Expiration: 1 month
Strike price: 1,600 (At-The-Money)
Premiums:
Call option premium (strike 1,600) = 15 points
Put option premium (strike 1,600) = 17 points
Contract size: 1 FKLI contract = RM 50 per point
Steps for Putting on the Short Straddle:
Sell a Call Option:
You sell a 1,600 strike OKLI call option.
You collect a premium of 15 points.
The total premium collected from the call = RM 50 × 15 = RM 750.
Sell a Put Option:
You sell a 1,600 strike OKLI put option.
You collect a premium of 17 points.
The total premium collected from the put = RM 50 × 17 = RM 850.
Total Premium Collected:
Total premium from both the call and put options = RM 750 + RM 850 = RM 1,600.
The maximum profit for the OKLI short straddle strategy is the total premium collected; for this example, it is RM1600. This profit occurs if FKLI stays at 1600 at expiration, and both options expire worthless. The maximum profit is also critical in calculating the upside and downside breakeven points.
To calculate the breakeven points, consider that the premium collected in this case is RM1600, equivalent to 32 index points. The short straddle will be making losses when the FKLI moves beyond the upper and lower breakeven points.
To get the upper breakeven point, add the strike price plus the premium collected = 1600 + 32 (points) = 1632
To get the lower breakeven point, deduct the strike price with the premium collected = 1600 - 32 (points) = 1568
Visualising the Short Straddle Strategy: Payoff Diagram
Figure 1 displays the visualisation of the strategy risk and reward potential for the OKLI short straddle strategy, where each of the numbers represents the important points:
Maximum Profit: 32 points (FKLI at 1600) = RM1600
Lower breakeven: 1600 – 32 = 1568
Upper breakeven: 1600 + 32 = 1632
Maximum loss (If FKLI declines to 1500): 68 points =RM3400
Maximum loss (If FKLI rises to 1700): 68 points = RM3400
The Rationale of Short Straddles
Selling straddles is an advanced strategy and risky unless you find markets that will not move substantially away from the strike price. Markets tend to alternate between trends and range-bound phases. The opportunity for short staddles arises when the markets move into consolidation and become rangy. As shown in the payoff diagram above, this strategy has a limited reward and unlimited risk payoff. So, correctly selecting the underlying assetand understanding the expected price movement and timing is crucial when trading short straddles.
While a short straddle can offer a high probability of success under stable market conditions and generate steady income, knowing this strategy's significant risks and challenges is vital.
Risk Management For Trading Short Straddles
The following risk management rules are helpful when trading short straddles:
Set Stop-Losses or Exit Points
Predefine your maximum acceptable loss for the trade, and stick to it. You must set stop-loss orders to limit the downside if the market moves too far from the strike price.
Example: You could set a stop-loss at a percentage of the collected premium or a predefined dollar amount, ensuring that losses don't get out of control.
You can set alerts for price levels where the underlying asset reaches critical thresholds, allowing you to exit manually before significant losses occur.
Monitor and Adjust Positions Actively
Be proactive in managing the position. If the market starts trending away from the strike price, you can roll the straddle by moving the short straddle to new strike prices closer to the current underlying price. Do this by buying back the current options and selling a new straddle at higher or lower strike prices, keeping the position active while adjusting to new market conditions.
Alternatively, you can close one side of the straddle. Should one leg (either call or put) move deeply in-the-money, close that leg and leave the other open if the market stabilises. Closing one side helps to minimise loss on the losing leg while potentially retaining the premium from the remaining leg.
Avoid Trades Around Major News Events
Avoid trading short straddles around earnings reports, economic data releases, or central bank meetings where large, unexpected market moves are likely. Volatility can spike significantly, causing massive losses. Ideally, you should enter the short straddle during periods of stability when the market is range-bound.
Alternatively, you can close the position ahead of key events to avoid massive movements that could create huge losses on the straddle.
Always Watch the Volatility.
You want to sell straddles when implied volatility is high and expected to decrease. High implied volatility means you can collect more premiums, which provides a bigger buffer against potential price movement. However, if implied volatility is low when you initiate the trade and later spikes, the position could lose value quickly. However, traders should be aware of the risks associated with entering positions when volatility is already high and may continue to spike due to unforeseen macroeconomic or event related shocks.
Time Your Trade Entry
Choose to enter short straddles when there is a relatively shorter time until expiration but enough time for the premiums to remain attractive. As options approach expiration, time decay (theta decay) accelerates, allowing you to capitalise on the rapid erosion of the premium. However, you want to avoid holding the straddle too close to expiration, where even small movements can lead to large swings in the option's value.
Use a Delta Hedging Strategy
To offset some directional risk, traders can buy or sell the underlying asset to hedge the short straddle's delta (directional exposure). If the underlying price moves too far from the strike price, adjusting the delta exposure through the underlying asset can help reduce risk.
Other Considerations When Trading Short Straddles
The required margin or capital needed for a short straddle is high due to the significant risk of loss, and it can escalate if the market moves away from the strike price. Straddles demands a more substantial capital commitment and exposes traders to margin calls if they don't have sufficient funds. Hence, traders must be aware of these capital constraints and manage risk carefully.
For traders considering short straddles, the strategy's primary advantage lies in its ability to leverage time (theta) decay, allowing traders to benefit as options lose value over time. Additionally, when used thoughtfully, short straddles can be a powerful tool for traders with a neutral market outlook to maximise returns without committing directional risk. However, the importance of vigilant risk management cannot be over-emphasised, particularly for new or intermediate traders who might underestimate the downside risk.
Related Articles
