How To Play A Short Straddle

Short straddle is a strategy when a trader sells or shorts calls and puts of the same stock, same strike and same expiry. It is a risky trade but can be managed.

Short straddle is exact opposite of long straddle. It is a very risky strategy as the losses can be unlimited. Please do not try this strategy unless you are an expert. You can try this if you have strict stop loss in the system. But in India we cannot put a GTC (good till cancelled) orders. So here in India it becomes a very risky strategy.

What is Short Straddle?

A short straddle is a trade when a call and a put are shorted/written/sold of the same stock/index, of the same strike price and of the same expiry.

For example as of writing Nifty today closed at 7367.00

Now let us suppose a trader feels that for the next 30 days Nifty will not move much, so he plans to sell a June 2014 7400 call and 7400 put. Let us see how much they are available now.

26-Jun-14 CE 7,400.00 142.00
26-Jun-14 PE 7,400.00 136.00

Let us assume he got these best prices and he sold them. Total points = 278. Total cash received in his account: 278 * 50 = Rs. 13,900.00

Do not be happy that this trader has received a huge amount in his account. Now his job is to protect this cash.

I hope now it is clear what a short straddle is. If the trader is lucky it can be a very profitable trade. But how many times were you lucky trading? Can anyone make money trading the stock markets just by luck? No.

Short straddle done. What’s next?

I have written earlier – the trader’s job is now to protect the income received. The first thing he will do is to calculate the breakeven point. 278 was the total points received.

So the upper BE: 7400 + 278 = 7678
And the lower BE: 7400 – 278 = 7122

Hope it’s clear – if Nifty starts to move beyond this range the trader will start to lose money. And he will have to do something very quickly to make sure the losses do not escalate. It is something that every trader should be worried about.

Note: Exact opposite is the long straddle. If the stock moves beyond the break even points the trader will start making money. The short straddle trader will lose and that is the name of the game called stock markets. 🙂

How to adjust a short straddle gone wrong?

1. It’s a very risky trade. In my view you should not trade this at all. But even if you have done – the best way to adjust any trade gone wrong is to take a stop loss. Get out of the trade if it has crossed the break even points or the losses are more than a certain percentage of the credit received. Some people keep this fixed at 50% of the credit received while some keep this at double the cash received.

Taking the above trade as an example:

The trader received Rs. 13,900.00 trading the short straddle. So he will not take a stop loss till the losses are 13,900*2 = 27,800. Once this figure is reached they will close both the positions – the call and the put. Total losses are still at 13,900.00, because from the 27800, 13900 that the trader received will be deducted.

Some traders keep this at a conservative 20% of the cash received. Ideally the stop loss should be kept at the total amount the trader is comfortable losing. You cannot keep it at Nifty Break Even points level or at some Nifty level. Why? Because a short straddle is Vega dependent too.

Lets assume the markets did not move after the announcement. But that does not mean that the short straddle trader is winning. The news could be confusing and the volatility may explode. If volatility increases, both the put and the call will increase in value and the short straddle will lose money.

Note: In reality short straddle is very tempting to play. Usually when a major event is to take palace or some big news is expected in a stock – the market makers will increase the volatility. Why? Because if they don’t, the values of the calls and the puts will be the same as before and for a seller of these options it gets very risky. If you are getting a lot of money for a huge risk you may be willing to take the risk. But if you are getting little money will you take that huge risk? No one will. Therefore to make a level playing field for both the sellers and the buyers the market makers increase the volatility. Moreover trades just wont take place if the calls and puts are not valued attractively before a big news or event. The buyers will not find any sellers.

Now it should be clear its obvious that if the calls and puts are not rightly priced, no one will come forward to sell. In that case if there are no sellers, there cannot be any buyers. So no trade will take place before a major event. Who loses money in that case? The market makers! More trades means more money for the people who own the stock markets and of course the brokers. The owners of the stock exchange want their brokers to be profitable too as they act as marketing agents and get them clients. If they are not profitable they will leave the business and owners of the stock exchanges will also lose money.

This is justified too. Why should a trader take a risk for too little in return during abnormal times?

So short straddle should be played when the volatility is very high and important news is awaited. Once the result is out or the announcement is made – the volatility gets shrunken and the trader makes money because the value of the calls and puts declines significantly.

Both the high volatility and the huge cash receivables is the tempting factor to play a short straddle.

Coming to managing the trade: The best way is to close the trade once your predetermined level of losses is reached. However as said earlier this is a very risk trade. Usually the news is declared when the markets are closed for the day. So you don’t know where the markets will open the next day. One thing is for sure the volatility will get crushed, but you will never know where the market will open the next day and where it will go from there. When they open you may find that markets have already surpassed your predetermined level of losses and therefore you will have to close the trade at a much bigger loss. However if the level is not reached but you feel it may be reached, you can close the trade early too. Your losses will be less.

2. Another great way to manage a short straddle is to buy naked calls or puts depending on where the markets are heading. For example if the news was bad, you can buy closer to the money puts. Remember that now they are available at relatively cheap prices, you can afford to buy them. If the puts are cheaper than the total money received, and if they are ITM than the put sold, you will not lose money if markets go in the same direction. In fact if you buy more puts than the no of puts sold, you will make money. Similarly you should buy ITM calls if there was some good news. But you got to this as soon as possible. Hoping that the markets will not move further can be catastrophic. You have taken unlimited risk. Do not leave this on luck.

3. If buying calls or puts are very costly then you can sell credit spreads against the losing position. For example if the markets are going up after the news, you can sell put spreads. And if markets are falling you can sell call spreads. But this will give you limited profit. And if there is a whipsaw you will start losing money in the spreads sold.

4. Exactly opposite of selling the spreads, you can buy the spreads. Buying spreads will reduce the cost of buying naked calls or puts. But again your gains will be limited. Same as 3 – a whipsaw means you start losing money in the newly bought spreads.

When to trade a short straddle?

As written above, one or two days before a major event is going to happen or some major announcement is to be made on a stock or markets in general. For example, budget announcements or general elections. For stocks it can be earnings report.

For example the India VIX (Nifty volatility) on 15th-May-2014 was around 44 (one year high) and when the general elections results were declared on the very next day – it crushed to around 25. It was still not very profitable for the short straddle traders because the markets open huge gap up of around 4%. People who bought deep ITM calls only probably made money. But ITM calls were very costly. ATM calls were going at around 300. So 300 * 50 = Rs. 15,000.00 was at risk for just one lot of Nifty option. Similarly someone selling a short straddle would get around Rs. 30,000.00. Isn’t this tempting? Still that trader would have lost money.

BTW what did I trade? I did the double diagonals and made small money. 🙂 Better than losing money.

If you stick to my advice, short straddle as a trade should be avoided. There are better trades during these times. Don’t get tempted.

When to exit a short straddle if next day you see that the trade is profitable?

It will be suicidal to wait till expiry. You don’t know where the markets will go in a few days. Even if you are making a small profit, its advisable to exit such high risk trades.

Have you ever tried a short straddle? If yes what was your experience?

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