Posted in Finance, Accounting and Economics Terms, Total Reads: 95
Definition: Short Straddle
Short Straddle is a combined call and put option with same strike price and expiration date. It provides the benefit of both the options in a single instrument. The option writer fixes the strike price and the expiration date for the instrument and provides the return on exercising the option. A premium has to be paid to the writer for making such a contract.
For example: if an investor enters into a short straddle agreement with an option writer creating a call and put option of a bundle of 100 stocks of a company with exercise price of 100 INR and a fixed expiration date and a premium of 1000 INR has to be paid by the investor, then if within this expiration date if the stock price moves from 100 to 110 then the writer has to pay the difference 1000 INR (100 stocks*10 INR) to the investor and if the stock prices moves from 100 to 90 INR then also the writer has to pay a difference of 1000 INR to the investor.
But if the price still remains 100 INR till the expiration date then the investor will not exercise his option and the writer will gain the premium out of this short straddle agreement.
So it is a very risky agreement for the writer as his profit is fixed or limited but his loss can be infinite. His maximum profit will be the premium he will get for entering into such an agreement and the stock prices remain same as the strike price but his loss will be the difference in the rise of stock prices which can be a huge amount. This type of option can be undertaken by writer if there are good chances that the price of the underlying stock will be almost neutral or not much movement will be there in the price of stocks.