Continuing further from our earlier part on Short Straddle Options Trading Explained: Example & Payoff Charts , here are the details about Profit & Loss Calculations for Short Straddle Options Trading

What are the breakeven points for the Short Straddle Option ?

Break even points are the points or spots when there is no profit - no loss for the option trader. i.e. they are the points either side of which there is a profit area and a loss area.



Upper Breakeven Point of Short Straddle Option = Strike Price of Short Call + Net Premium Received

i.e. $50 + $10 = $60

Lower Breakeven Point of Short Straddle Option = Strike Price of Short Put - Net Premium Received

i.e. $50 - $10 = $40

What is the maximum profit for Short Straddle Option Trading Position?

The profit from Short Straddle is LIMITED or capped.

As we can see from the final net payoff function PINK colored graph for the Short Straddle Option, the maximum profit appears on the peak point only - and that is at the ATM strike price. Maximum profit comes only when the underlying stock price ends at the ATM strike price on the expiry date. None of the short options (call or put) gets exercised and the Short Straddle Options trader gets to keep the entire option premium as profit ($10 in this case - the Option Brokerage)

However, since the underlying price may not really end at the ATM strike price, the profit varies. As the underlying price moves away from the strike price of $50, the profits starts to reduce in either direction.

Maximum Profit for Short Straddle = Net Premium Received - Option Brokerage Commissions

Profit from Short Straddle will be achieved only when Price of the Underlying stock remain in a range - higher than the Lower breakeven point and lower than the Upper breakeven point

Profit from Short Straddle = Price of Underlying - Strike Price of Long Call - Net Premium Paid

OR

Profit from Short Straddle = Strike Price of Long Put - Price of Underlying - Net Premium Paid

But please note that the option traders must also account for the option brokerage which they pay for entering into & exiting from the Short Straddle positions. You will short 2 options to enter the Short Straddle, and 2 trades to exit the Short Straddle (or at least one of them will get exercised). Hence, those brokerage and commissions should also be deducted to get an exact amount of profit value.
What is the maximum loss for Short Straddle Option Trading?

Theoretically, the maximum loss you can suffer on this Short Straddle Option Position is UNLIMITED. Hence, only experienced options traders are advised to try the Short Straddle Trade. Remember, you are taking a shot on two-sided sword. If the stock price makes a big move in either upward or downward direction, you will take a very big loss. There are 2 possibilities working against you (big move in either direction) and only one in your favor (no big move).

Irrespective of your level of expertise in options trading, you MUST keep strict stop loss.

Maximum loss of Short Straddle Option = Price of Underlying - Strike Price of Short Call - Net Options Received + Option Trading Brokerage (at exit or exercise)

OR

Maximum loss of Short Straddle Option = Strike Price of Short Put - Price of Underlying - Net Options Premium Received + Option Trading Brokerage (at exit or exercise)

Loss will occur when at expiry the underlying stock price ends up greater than (Strike Price of Short Call + Net Premium Received) OR Price of Underlying ends up less than the (Strike Price of Short Put - Net Premium Received). Even a 1 point move either way will trigger one of the options to be exercised which might incur more brokerage charges (depending upon your broker).

What are the risks in trading Short Straddle Option ?

Short Straddle is considered to be one of the riskiest bets in the options trading - it should be traded only by experienced options traders that too with strict stop loss with a constant monitoring. Remember, in short straddle, you can loose much more than the limited profit potential you are targeting for.
- There is a guarantee of atleast one of the (call or put) option getting exercised. Apart from the exercise money, you might end up paying exercise brokerage to your option broker that will be a cost to you.

- Bid-Ask Spread will surely have a bad impact - while shorting, you may not receive the correct price and while squaring off you may again not get proper price.

- Constant monitoring of price of both the underlying as well as (call & put options) is required. The options pricing still goes weird at times which means you are at a risk.

- Time decay will benefit this Short Straddle position. Hence it is advisable to enter this position with a maximum of 1 month to expiry since time decay rate is highest in the last month. (See Options Time Decay: Explained with Examples).

- Note that this is a double Short position - which means the option trader will need to keep high amount of margin money with his broker for both the short positions

- Avoid taking short straddle positions on index options - stocks can still be better forecasted for stability in price movements, but indices are constituted by multiple stocks and they may make big moves because of few heavyweights leading to more probability of losses.

- Remember this is a very HIGH RISK strategy - you may loose much more than what you potentially can receive in profit

Let's head on to next part Tips to Enter & Exit Short Straddle Options Trading Position