Thread by @AlgoTest_in

🧵 #AlgoTestExplains (#2) : How do you trade the short straddle?

In this week's edition of our new series, we're going to be talking about how the short straddle can be deployed to make money WITH and WITHOUT delta hedging 📈

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Firstly, the intraday theta when selling options can be thought of as your compensation for the asymmetric risk that you’re taking on when selling a straddle.

The buyer is paying you this amount for the day.

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The maximum profit for the trade is limited to the max theta for that particular day, everything else remaining the same.

Let’s have a look at the greeks of our position:

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Delta = 0 (sold ATM CE, PE, each of delta 0.5)
Gamma = -ve (little/no movement in underlying is usually good for us)
Vega = -ve (A decrease in IV is generally good for our position)
Theta = +ve (the passage of time is good for us)

Now, let’s consider 3 distinct scenarios.

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A)Choppy Markets (V,M,W markets)

If we expect the market to be choppy but in a generally defined range, we’ll benefit*typically* by NOT delta hedging.

Let’s understand with a “V” shaped market.

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Say the market begins to trend down in the range. Our net delta will be positive as the market falls.

In order to hedge, we must sell the underlying to retain delta neutrality.
However, since we expect the market to trend back up (V move), we will lose on the hedge.

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Once the market is back up, since our gamma < 0, we'll end up having short deltas!

Now, we'll have to buy the underlying back at a price higher than the price at which we sold it.

We’d be selling low and buying high to remain delta neutral; this is counter-intuitive!

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So how exactly do we make money in a V,M,W market?

If the market trades in its range AND the IV reduces, our position will benefit and we’ll make money!

If IV stays the same, EAT THETA!

But what would our plan of action be in the case of a trending market?

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There’s 2 ways we can approach it; with delta hedging and without.

B)Trending markets Case I: With delta hedging

When the market trends in one direction, we can choose to delta hedge.

Essentially, the idea is to lose as little as possible & try to feed off of theta.

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For instance, if the market trends upwards, our CE leg will lose money and our PE leg will make money.

As a result, the net delta of our position will be -ve.

In order to be delta neutral, we will buy the underlying.

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If the market continues to trend upwards, we'll once again buy the underlying.

In this way, we're losing more and more on the CE leg as it goes deeper ITM, but our hedges (🤞) roughly offset this loss as we’re making money on them since the market continues to trend up.

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The more intense the move up, the more we lose due to gamma.

If the underlying slowly drifts up, it might not be that bad for us!

If we’re delta hedging, lets hope the market doesn’t reverse!

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C)Trending markets Case II: No *explicit* delta hedging

We can now maybe use our classic 9:20 straddle template 😁

If we have a SL set on our legs, the active leg whose SL has not been triggered can make us money (via delta AND theta).

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Note that the leg where the SL gets hit is essentially a delta rebalance!

Think about it, if the market goes down, your short put becomes ITM and your short call becomes OTM.

Your net position delta is positive.

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As soon as you close out your short PE as its losing money, you’re only short the call, so you’ve flipped from being positive delta to negative delta!

Now pray to #OperatorBhaiya that the market keeps falling ;)

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