A Straddle is a volatility strategy and is used when the stock price/index is expected to show large movements.
In a Short Straddle, the investor feels the market will not show much movement. So, they sell a Call and a Put on the same stock/index for the same maturity and strike price. It creates a net income for the investor. If the stock/index does not move much in either direction, the investor retains the premium as neither the Call nor the Put will be exercised. However, in case the stock/index moves in either direction, up or down significantly, the investor’s losses can be significant. So, this is a risky strategy and should be carefully adopted, and only when the expected volatility in the market is limited. If the stock/index value stays close to the strike price on expiry of the contracts, the maximum gain, which is the premium received, is made.
When to Use: The investor thinks that the underlying stock/index will experience very little volatility in the near term.
Risk: Unlimited
Reward: Limited to the premium received
Breakeven
- Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
- Lower Breakeven Point = Strike Price of Short Put - Net Premium Received