Short Call Synthetic Straddle Explained

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Really Pretty Real: Understanding Synthetic Options Strategies, Pt 1

Learn how synthetic options strategies can help traders potentially lower transaction costs, improve price discovery, and more efficiently use capital.

Back before option pricing models and mathematical greeks—we’re talking delta, gamma, theta, vega, and rho, not the ancient Greeks (Socrates, Aristotle, Plato)—floor traders used synthetic positions to price options. Synthetics are positions that mimic the risk/reward profile of another position, typically using some combination of stock and options. Understanding synthetics gave those floor traders a strong foundation and deep knowledge of options. I want to help you gain the same insight into options strategies by explaining how to use and interpret synthetics.

Back in the day, floor traders used synthetic positions for arbitrage, which is a trading strategy that seeks to lock in a risk-free profit by buying one investment and simultaneously selling a similar or related investment at a different price. This arbitrage was available in the early days to options traders on the floors of the exchanges. But today, with the increase in computing power and brilliant PhDs coding algorithmic trading strategies, these arbitrage opportunities are difficult to come by for the remaining floor traders and for retail traders trading from their screens.

Nevertheless, understanding synthetics still offers the options trader several potential benefits:

  1. They can help lower transaction costs
  2. They can help with efficient price discovery
  3. They can provide more efficient use of capital and flexibility

The Skinny on Synthetics

Before we get into the details of how these benefits work, let’s take a minute to relate synthetics to plain-vanilla options strategies. This is really quite simple. Ordinary options strategies with the same strike price and expiration month all have synthetic equivalents. And because of the relationship between calls, puts, and their respective underlying stocks, synthetics have profit/loss and risk profiles that are similar to regular options.

Option Position Synthetic Position
Long call Long put + long stock
Long call Long stock + long put
Long put Long call + short stock
Short call Short stock + short put
Short put Long stock + short call
Long stock Long call + short put
Short stock Long put + short call
Long straddle Short stock + long 2 calls
Short straddle Long stock + short 2 calls
Short put vertical Long call vertical: same strikes
Short call vertical Long put vertical: same strikes

Fewer Transaction Costs

Because of these relationships, synthetics can be used to express changing opinions about the direction of the market without closing out an existing plain-vanilla trade. By executing fewer trades, traders can potentially save on transaction costs. Let’s walk through some examples to see where the savings might come from.

Suppose a trader is already long a put, but he thinks the market might go higher and wants to get bullish, too. He could sell the put and buy a call, which would incur two commission fees. Or, he could buy the underlying stock and hold on to the put. That’s just one commission. This works because a long stock + long put on the same strike and month is equivalent to a long call.

Here’s another scenario. Suppose a trader is long a call and decides to get short the market. Instead of selling the call and buying a put, it might be cheaper to short the stock and hold the call. A long call + short stock on the same strike and month is equivalent to a long put.

What if a trader is unsure about direction, but wants to express an opinion about changing volatility?

Say the trader is long two calls. She’s unsure about which way the stock might move, but she thinks it could be a big move in a short time period. Maybe there’s an earnings announcement, court case, or some other binary event coming up. She could enter a long straddle to potentially profit from an increase in volatility. Instead of buying two puts, she could short the stock, because short stock + long two calls is equivalent to a long straddle.

Suppose a trader is short two calls and is unsure about direction, but he thinks the stock might experience a small move in the short term. He wants to enter a short straddle. Instead of shorting two puts, he could buy the stock. Long stock + short two calls is equivalent to a short straddle.

All clear yet? Synthetics can seem confusing, but they’re really just different ways of looking at—or possibly trading—a position with the same profit/loss and risk profile. We’ve seen how synthetics can potentially offer fewer transaction costs versus trading garden-variety options. In Part 2, we’ll look at how synthetics can offer a couple more benefits: efficient price discovery and efficient use of capital.

Spreads, Straddles, and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades.

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Short Combination

AKA Synthetic Short Stock; Combo

The Strategy

Buying the put gives you the right to sell the stock at strike price A. Selling the call obligates you to sell the stock at strike price A if the option is assigned.

This strategy is often referred to as “synthetic short stock” because the risk / reward profile is nearly identical to short stock.

If you remain in this position until expiration, you are probably going to wind up selling the stock one way or the other. If the stock price is above strike A, the call will be assigned, resulting in a short sale of the stock. If the stock is below strike A, it would make sense to exercise your put and sell the stock. However, most investors who run this strategy don’t plan to stay in their position until expiration.

At initiation of the strategy, you will most likely receive a net credit, but you will have some additional margin requirements in your account because of the short call. However, those costs will be fairly small relative to the margin requirement for short stock. That’s the reason some investors run this strategy: to avoid having too much cash tied up in margin created by a short stock position.

Options Guy’s Tips

It’s important to note that the stock price will rarely be precisely at strike price A when you establish this strategy. If the stock price is above strike A, you’ll receive more for the short call than you pay for the long put. So the strategy will be established for a net credit. If the stock price is below strike A, you will usually pay more for the long put than you receive for the short call. So the strategy will be established for a net debit. Remember: The net credit received or net debit paid to establish this strategy will be affected by where the stock price is relative to the strike price.

Dividends and carry costs can also play a large role in this strategy. For instance, if a company that has never paid a dividend before suddenly announces it’s going to start paying one, it will affect call and put prices almost immediately. That’s because the stock price will be expected to drop by the amount of the dividend after the ex-dividend date. As a result, put prices will increase and call prices will decrease independently of stock price movement in anticipation of the dividend. If the cost of puts exceeds the price of calls, then you will have to establish this strategy for a net debit. The moral of this story is: Dividends will affect whether or not you will be able to establish this strategy for a net credit instead of a net debit. So keep an eye out for them if you’re considering this strategy.

On the other hand, you may want to consider running this strategy on stock you want to short but that has a pending dividend. If you are short stock, you will be required to pay any dividends out of your own account. But with this strategy, you’ll have no such requirement.

The Setup

  • Sell a call, strike price A
  • Buy a put, strike price A
  • The stock should be at or very near strike A

Who Should Run It

NOTE: The short call in this strategy creates theoretically unlimited risk. That is why it is only for the most advanced option traders.

Synthetic Straddle

Synthetic Straddle – Definition

A combination of stocks and call options which produces the same payoff characteristics as a Long Straddle options trading strategy.

What Is Synthetic Straddle?

Synthetic Straddle transforms a basic stock position into an options trading position that profits even when the stock goes down the same way that a long straddle options trading strategy does. This is useful when a stock you are holding is expected to move up or down strongly and you want to profit either way without having to sell your stocks. This is the kind of flexibility that options trading grants through the use of Synthetic Options Strategies.

When To Use Synthetic Straddle?

How To Use Synthetic Straddle?

There are 2 main ways to establish a Synthetic Straddle. One way is by buying twice as many At The Money (ATM) call options as you have short stocks , known as the Long Call Synthetic Straddle. The other way is by buying twice as many At The Money (ATM) put options as you have long stocks , known as the Long Put Synthetic Straddle.

Making Long Put Synthetic Straddle from Long Stock.
Example : Assuming you own 100 shares of XYZ company trading at $40 now. To transform the position into Synthetic Straddle, you will buy 2 contracts (representing 200 shares) of XYZ’s $40 put options.
Making Long Call Synthetic Straddle from Short Stock.
Example : Assuming you are short 100 shares of XYZ company trading at $40 now. To transform the position into Synthetic Straddle, you will buy 2 contracts (representing 200 shares) of XYZ’s $40 call options.

At this point, experienced options traders would notice that establishing a Synthetic Straddle actually creates a Delta Neutral Position.

Making Long Put Synthetic Straddle from Long Stock.
Example : Assuming you own 100 shares of XYZ company trading at $40 now. To transform the position into Synthetic Straddle, you will buy 2 contracts (representing 200 shares) of XYZ’s $40 put options.
100 shares = 100 delta. 200 ATM Put Options = -100 Delta (-0.5 delta each).

Total Delta = 100 – 100 = 0

Making Long Call Synthetic Straddle from Short Stock.
Example : Assuming you are short 100 shares of XYZ company trading at $40 now. To transform the position into Synthetic Straddle, you will buy 2 contracts (representing 200 shares) of XYZ’s $40 call options.
100 short shares = -100 delta. 200 ATM Call Options = 100 Delta (0.5 delta each).

Total Delta = 100 – 100 = 0

Profit Potential Of Synthetic Straddle

Synthetic Straddle offers unlimited profit whether the stock moves upwards or downwards.

Risk / Reward Of Synthetic Straddle

Maximum Profit: Unlimited

Maximum Loss: Limited
(Limited to extrinsic value of options bought when stock remains stagnant)

Breakeven Point Of Synthetic Straddle

There are 2 break even points to a Synthetic Straddle. One breakeven point if the underlying asset goes up (Upper Breakeven), and one breakeven point if the underlying asset goes down (Lower Breakeven).

Upper Break Even = Option Strike Price + Extrinsic Value Of Options

Lower Break Even = Option Strike Price – Extrinsic Value Of Options

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Making Long Put Synthetic Straddle from Long Stock.
Example : Assuming you own 100 shares of XYZ company trading at $40 now. To transform the position into Synthetic Straddle, you will buy 2 contracts (representing 200 shares) of XYZ’s $40 put options at $1.50.

Upper BreakEven = $40 + ($1.50 x 2) = $40 + $3 = $43

Lower BreakEven = $40 – ($1.50 x 2) = $40 – $3 = $37

Advantage of Synthetic Straddle

Able to immediately transform a stock position into an options trading position which profits from either direction without closing the original stock position.

Short Straddle

Overview

Pattern evolution:

When to use: If market is near A and you expect market is stagnating. Because you are short options, you reap profits as they decay — as long as market remains near A.

Profit characteristics: Profit maximized if market, at expiration, is at A. In call-put scenario (most common), maximum profit is equal to the credit from establishing position; break-even is A +/– total credit.

Loss characteristics: Loss potential open-ended in either direction. Position, therefore, must be closely monitored and readjusted to delta neutral if market begins to drift away from A.

Decay characteristics: Because you are only short options, you pick up time-value decay at an increasing rate as expiration approaches. Time decay is maximized if market is near A.

CATEGORY: Precision
Short call A, short put A
SYNTHETICS:
Short 2 calls A, long instrument
Short 2 puts A, short instrument
(All done to initial delta neutrality)

Example

Scenario:
This trader finds a market with relatively high implied volatility. The current feeling is the market will stabilize after having had a long run to its present level. To take advantage of time decay and dropping volatility this trader sells both a call and a put at the same strike price.

Specifics:
Underlying Futures Contract: September Japanese Yen
Futures Price Level: 0.8600
Days to Futures Expiration: 40
Days to Options Expiration: 30
Option Implied Volatility: 12.6%
Option Position:

Short 1 Sep 0.8600 Call + 0.0100 ($1250.00)
Short 1 Sep 0.8600 Put + 0.0100 ($1250.00)
+ 0.0200 ($2500.00)

At Expiration:
Breakeven: Downside: 0.8400 (0.8600 strike – 0.0200 credit). Upside: 0.8800 (0.8600 strike + 0.0200 credit).
Loss Risk: Unlimited; losses increase as futures fall below 0.8400 breakeven or rise above 0.8800 breakeven.
Potential Gain: Limited to credit received; maximum profit of 0.0200 ($2500) achieved as position is held to expiration and futures close exactly 0.8600 strike.

Things to Watch:
This is primarily a volatility play. A trader enters into this position with no clear idea of market direction but a forecast of less movement (risk) in the underlying futures. Be aware of early exercise. Assignment of a futures position transforms this strategy into a synthetic short call or synthetic short put.

Additional Futures & Options Strategies

Contents Courtesy of CME Group.

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