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Short Straddle

short-straddle

1. Definition

The Short Straddle, also known as top straddle or straddle write,  consists in a neutral strategy that sells at the same time an ATM Call and an ATM Put at the same striking price and expiration date.

Selling a Call At-The-Money: selling a Call at a strike price as closer as possible to the share price. Sell a “Call” forces the holder to sell a share until the expiry date, for the striking price.

Selling a Put At-The-Money: selling a Put at a strike price as closer as possible to the share price. Sell a “Put” forces the holder to buy a share until the expiry date, for the striking price.


2. Objective

Making profits in a market heading to stability. The strategy is commonly used when the investor believes the share prices won’t change much, keeping up a certain pricing level. If the prices change unexpectedly, either upwards or downwards, the investor loses money.


3. How it works

In this strategy, an ATM Call is sold and a premium is earned. Simultaneously, an ATM Put is also sold, and another premium earned. initial liquidation value will be a credit, as both options were sold and resulted in an initial profit. Graphs converge as follows:

Call Sold + Put Sold = Short Straddle

Selling the Call

gráfico Short call_clean+

Selling the Call

gráfico Short Put_clean

=

Short Straddle

gráfico Short Straddle_cleanCaption:

Red = Losses

Yellow  = Small Losses

Green = Profits

Earnings: in this strategy, earnings are quite limited every time the proper asset keeps its prices at a similar level than the Put and the Call sold. The maximum gain is the credits obtained from selling the options. However, if the equivalent share prices change too much, the investor will accumulate losses.

Losses: losses are virtually unlimited. If the market moves either upwards or downwards, the investor registers a loss. It is crucial to follow the markets, adjusting position any time it’s necessary, if share prices move away from the price levels for both Calls and Puts sold.


4. Example

Consider the following data:

Asset:

Petrobrás

Date:

09/10/2013

Maturity:

10/21/2013

Share prices:

18,89

Days before expiration

41

Number of options

1.000

In order to proceed this operation, the investor needs to sell an ATM Call PETRJ19 receiving a premium of R$ 1.00 per option, and sell an ATM Put PETRV19, earning a premium of R$ 0.95 per option. Look at the summary below:

Summary:

Option   Type

Object

Series

Number of   options

Premium

Exercising price

Liquidation amount

Selling   Call

Petrobrás

PETRJ19

1,000

1.00

19

R$ 950.00

Selling   Put

Petrobrás

PETRV19

1,000

0.95

19

R$ 1,000.00

Total

1.95

R$ 1,950.00

By the expiry date, we shall have the following results, depending on the closing share prices:

Share prices by Expiry date

Call   Sold

Put   Sold

Total   Results

R$     13.00

950

-5,000

-4,050

R$     14.00

950

-4,000

-3,050

R$     15.00

950

-3,000

-2,050

R$     16.00

950

-2,000

-1,050

R$     17.00

950

-1,000

-50

R$     18.00

950

0

950

R$     19.00

950

1,000

1,950

R$     20.00

-50

1,000

950

R$     21.00

-1,050

1,000

-50

R$     22.00

-2,050

1,000

-1,050

R$     23.00

-3,050

1,000

-2,050

R$     24.00

-4,050

1,000

-3,050

R$     25.00

-5,050

1,000

-4,050

Results:

Results from this strategy are the exactly opposite from those got by using the Long Straddle. The investor fixed a landing price, in this case R$ 19.00. If share prices don’t change much, he will gets profits. If the shares moves too much, the investor will begin to make loss. If prices hike over R$ 19.00, he will be exercised on the Call, and will need to sell shares for R$ 19.00. However, as he got a premium by selling the option, a small profit is anyway taken. On the other column, if the share prices drop below R$ 19.00, he will be exercised on the Put, and will have to buy shares for R$ 19.00 each. The same happens here – as he got a premium by selling the options, profits are still being made to a certain level. Look at the following graph:

Short StraddleCaption:

Red = Losses

Yellow = Nor profits neither losses

Green = Profits

Earnings: the operation will results in profits if the Petrobras shares reach any level between R$ 17.06 and R$ 20.94 by the expiry date. The further the prices are from the R$ 19.00 by the expiry date, the lower is the income of the investor. The maximum earnings from the operation are equivalent to the sum of the premiums received (R$ 1.00 + R$ 0.95 = R$ 1.95).

Losses: the operation will result in losses if Petrobras shares reach any price below R$ 17.06 or above R$ 20.94. For these intervals, we’ll have one of the following situations:

PETRJ19: if prices for Petrobrás shares exceed R$ 19.00 by the expiry date, the investor will be forced to exercise a Call PETRJ19, selling a share for the strike price (more than R$ 19.00). For instance, if shares reach R$ 21.00, the investor must sell shares for only R$ 19.00, accounting losses of R$ 2.00 per share. However, as he made a small profit from selling Calls and Puts, losses will be mitigated. In this case, the PETRV19 will cease to exist, losing its value, leading to the following results:

Results: R$ 21.00 – R$ 19.00 – R$ 1.00 – R$ 0.95 = -R$ 0.05 per share

PETRV19: if prices are lower than R$ 19.00 by the expiry date, the investor will be forced to exercise the Put, buying Petrobras shares for R$ 19.00. If current prices are in R$ 18.00, for instance, he will be force to buy the shares at this price, registering a loss of R$ 1.00 per share. However, as he made a small profit from selling Calls (R$ 1,00) and Puts (R$ 0,95), losses will be mitigated. Then, total results from the operation are a profit of R$ 0.95 per share. In this case, the PETRV19 will cease to exist, losing its value, leading to the following results:

Results: R$ 19.00 – R$ 18.00 + R$ 1.00 + R$ 0.95 = R$ 0.95 per share

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