The Hindu Business Line : Short straddles and strangles

Over the last two weeks, this column discussed option strategies that are best suited for times of volatility; when you are sure of a movement in the market but not as sure on the direction of the move.

But what should you do when you think that the market or security will experience little volatility in the near-term? Exactly the opposite of a long straddle and a long strangle – a short straddle and short strangle. These deliver when volatility either remains the same, or decreases.

When to use these strategies?

Use these strategies only when you are sure that the price of the underlying is stagnating and will remain range-bound or sideways. That is, use them only when you expect volatility to either remain stable or decrease from present levels.

For instance, such strategies can yield decent profits when they are entered into, a week or two before the expiry date.

All things remaining the same, the option premium tends to erode as we near expiry and this helps when you have written (or sold) options. Note that both strategies profit from a time decay.

What is a short straddle?

A short straddle requires you to sell both a call and put option on the same underlying with the same strike price and expiration period.

Note that since the strategy involves selling of options you will receive option premiums, when you set this spread. However, you will be able to pocket this premium for good only when the underlying remains locked between the two breakeven points. Say you sell a short straddle on the Nifty.

You sell a Nifty 5000 put and call for Rs 200 and Rs 100 respectively. The breakeven for such a spread can be arrived at as follows:

Upper breakeven: Strike price + net premium received (in this case, 5300)

Lower breakeven: Strike price – net premium received (in this case, 4700)

You will be able to pocket the premium inflow of Rs 300 (or Rs 1500 per lot) only when Nifty closes between 5300 and 4700 levels.

Any move beyond these levels will expose the investor to the risk of the option being exercised.

So, the maximum potential profit point is only at the strike price at expiration, and large potential losses can happen, should the underlying move beyond range.

What is a short strangle?

A short strangle involves selling out of the money call and put options on the same underlying with the same expiry period. This strategy is quite similar to the short straddle.

However, it enjoys low-risk and low-return payoff. Low risk because the strategy offers a greater protection than short straddle since the underlying must move further to result in a loss. Low returns because the premiums received are lesser since options are out of the money.

The breakeven for this spread is calculated in the same way:

Upper breakeven: Strike price + net premium received

Lower breakeven: Strike price – net premium received

Risk of exercise

A short straddle and short strangle involve selling of options, which makes these strategies highly risky. Selling an option, gives the buyer the right and not the obligation to buy/sell the underlying at a specified price on or before expiry.

So, if anytime before expiry, the underlying breaches the breakeven points, you stand the risk of exercise. This can result in unlimited loss, as opposed to buying of options that limits your maximum loss. While a short strangle enjoys a lower risk of exercise as against a short straddle, any dramatic change in share price or increase in volatility can prove very unprofitable.

So, if the underlying makes any unprecedented move, you should consider closing the options.

Alternately, you can limit your potential losses by purchasing out-of-the-money put and call options in comparison to the options sold previously.

While the cost of buying these options will reduce your profit potential, it also contains your loss; and hence a must for traders with a lower-risk appetite.

The fine print

Do not set this strategy for far month contracts. Remember, time value does not act against you and hence it will be more profitable to set these spreads in the near month (current month) contracts.

However, since they are essentially high risk strategies, enter them only when you are sure that the potential risk vs. reward scenario matches your own risk-taking ability.

Note that any undesirable movement in the underlying or increases in volatility pose a risk to your positions. This makes it imperative that you track your positions constantly.

Also be prepared to shell out some money for margin maintenance since you will be a seller of calls and puts.

Most importantly, make sure you have plenty of time and a strong heart, just in case the spreads turn out of the money.

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