Today
we’re going to cover the Short Straddle for options investors. This option
strategy consists of two legs, the Sale of a Call option and the Sale of a Put
option with the same expiration date
and the same strike price. And we’ll
explain this strategy further using a BinckBank case study.
Application
A Short
Straddle can be used in a variety of different ways:
- You anticipate little market price movement in the short term;
- The expected value of both options decreases daily In line with the diminishing remaining term of both options
- You anticipate a short-term decline in volatility;
- The value of the Call and the Put option decreases due to a lower volatility.
It
is not necessary to sit on a Short Straddle until expiration. The option
premium reduces on a daily basis.
Time
is your friend.
BinckBank Case Study
The
share is listed at EUR 8.01 (based on closing prices Friday, 8th March).
Suppose
that you believe the market price of BinckBank will move little in the coming
month. You want to exploit a small market price movement (<5%) with a Short
Straddle.
Investment
Initially
you’ll receive money: (price of the sold Call option plus the price of the sold
Put option) * contract size * the number of contracts that you sell.
Suppose
you sell 10 Call options BCK Apr-13 8.00 for 0.70 and you sell 10 Put options
with the same expiration and strike price for 0.75. Then you’ll receive a balance
of EUR 1,450 (= (0.70 + 0.75) * 100 * 10).
Be
careful. 1.45 at a market rate of 8.01 is a whopping 18.1%.
Margin
As
both options are short, there is a margin requirement. Banks and brokers are
free to determine these themselves. Under the old stock exchange rules, the
margin requirement in this Short Straddle would amount to around EUR 200. At 10
Short Straddles that equals EUR 2,000 (= 10 * EUR 200).
Your
net investment will amount to EUR 550 (EUR = 2000 - 1450).
Profit and Loss Chart
The
graphical simulation for the Short Straddle looks like this:
The
blue line indicates the theoretical profit as of today.
The
red line shows the return upon expiration.
Break-Even Point & Profit
If
the market lists the price at more than 6.55 (-18.2%) and less than 9.45
(+17.9%) upon expiration then you’ll realise a profit using this strategy.
You
can easily calculate the break-even points upon expiration on the back of a
cigarette packet by taking the strike price minus the premium received (8.00 -
1.45 = 6.55) or the strike price plus the premium received (8.00 + 1.45 =
9.45).
Maximum Profit
If
the market rate upon expiration is equal to the exercise price of 8.00, then
you’ll realise the maximum profit of 1.45 using the Short Straddle. 10 units
are equal to EUR 1,450.
The
return then amounts to 263% (= 1.45 / 0.55 * 100%, or 1450/550 * 100%).
Maximum Loss
Your
maximum loss is unlimited, because you hold a short position. This applies
downwards and upwards. If BinckBank crashes to EUR 12.50 upon expiration for
example, then your Short Straddle will go wrong.
You
would suffer a loss of 3.05 (= 12.50 -8 .00 = 4.50 - 1.45). 10 units equal EUR
3,050.
To
limit this maximum upward loss, you can purchase an out of the money Call (in
advance). For protection. For example, the Call Jun-13 10.00 for 0.43. The
advantage with this type of Call with its long maturity, is that if it is
successful upon the April expiration, it can also be used for the May and even
the June Long Straddle. In other words you can use the insurance 3 x if necessary.
The
graphical simulation for this Protected Short Straddle looks like this:
High Risk
The
disadvantage of the Short Straddle is that you can lose money either way. Both
a large increase and a significant decrease in market price can lead to
substantial loss.
In
addition, you’ll not benefit from turmoil within the market. Turmoil in the
market will increase volatility, resulting in higher option premiums.
You
can see the impact of volatility in the graph below:
At
the current market rate, the Vega Position is now minus 21 euros.
Advantages
The
advantage of the Short Straddle is that small price changes and constant
volatility will earn you money on your position on a daily basis.
You
can predict the size of the profit from the Theta of the position. The graph
reveals that at the current market rate, this will yield around 18 euros per
day.
This
amount will increase as the maturity decreases.
A
second advantage is that if the volatility decreases, the value of the option
premiums will also decrease.
Volatility 68%, Percentile at 99%
The
Implied Volatility Index Percentile is a good indicator of whether Volatility
is high or low. This Volatility indicator shows on a historical basis what
percentage of Volatilities was recorded at less than the current Volatility.
For BinckBank this percentile is at 99%. The current Volatility (68%) is therefore
extremely high. Historical Volatility is low; 32%. Interesting for writing premiums.
But be careful!
Pitfalls
Some
of the pitfalls associated with a Short Straddle are:
- Events. If volatility increases then value of the Short Straddle rises sharply and that costs money. Avoid events throughout the term of your position.
- Dividend. Short options can be assigned. Avoid ex-dividends.
- You make a loss over time if the market moves too much. Unless you hedge in order to limit your maximum loss.
- Don’t wait until the last day to take your profit because the Short Straddle will never end exactly at 0. If you can close your position at 0.30 in the example above, you will have done good business.
Consider
investing in Short Straddles with a short maturity (1-2 months) instead, which
offer a higher Theta (the premium reduces by more each day) than Short
Straddles with a longer maturity.
An
interesting alternative is to combine the Short Straddle with shares. But more
about that next time.
Please
note that this example is for illustration and education purposes only and does
not incorporate transaction costs. This example is not a recommendation.
Herbert
Robijn is founder and director of FINODEX (www.finodex.com).
FINODEX develops innovative online investment tools for private equity and
options investors. These cutting-edge tools allow investors to make a
comprehensive market analysis, complex calculations and appropriate selections,
at just the touch of a button.
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