In case of short straddle, though the investor earns an income, one should use it with extreme caution as the losses could be high if the expectations of limited volatility prove incorrect.
Short Straddle: This strategy is the reverse of long straddle and is implemented by selling a call and a put option with the same underlying security, strike price and expiry date.
Rajesh purchases 6,450 RST Index options and enters the long straddle; Naveen sells 6,550 RST Index options and enters short straddle. The cost of trade for long straddle is Rs 9,500 [(100+90)x 50], and for short straddle, it is Rs 9,250 [(80+105)x 50].
Short straddle reaches its break-even points at 6,365 and 6,735.
The short straddle is created by selling a call and a put for the same strike price; usually, at the money.
Figures 41.13 and 41.14 show the profit profile of a long straddle and a short straddle, respectively, where the current stock price and both strike prices are equal to 50.
The striking feature in Figure 5 is that equity behaves like a short straddle. In options markets, short straddles are achieved by simultaneously selling a put and a call on the same underlying asset.
The fact that the equity of a life insurance company may resemble a short straddle is not new.
To clarify why a short straddle is obtained, it is useful to disentangle the various effects at play on the asset side and the liability side.