Short Put Synthetic Straddle Explained

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Short Put vs Long Put Explained

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In the world of options trading, what is the difference between trading a short put and a long put?

A long put option gives you the right, but not the obligation to sell an underlying asset at a specific price at a specific date in the future.

Therefore, if you sell a put contract, as in “sell to open,” you take on the obligation of having to buy an underlying asset at a specific price in the future.

If you buy a put contract, as in “buy to open,” you retain your right, but not the obligation, to sell the underlying asset at a specific price at a specific date in the future. It is always the sellers of options who can be assigned an underlying asset (depending on the asset’s specifications) at any time.

Simply put, no pun intended, a short put compared to a long put is exactly like it sounds: they are opposite options trading strategies.

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A short put graph looks like this:

A long put graph looks like this:

Is the Profit/Loss the Same for a Short Put vs a Long Put?

The short put option strategy and the long put option strategy both have a limited loss as well as a limited profit. The limited loss for a short put, however, is far more severe than for a long put.

The risk when purchasing a put is always that the put premium will decline in value and will expire worthless. The price of the premium is always the maximum possible loss for a long put.

For a short put, the underlying asset technically has the possibility of going to zero. Although this means that the maximum loss is not unlimited, the maximum loss is severe. Consequently, this means the maximum profit for a long put is very substantial.

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Long Combination

AKA Synthetic Long Stock; Combo

The Strategy

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

This strategy is often referred to as “synthetic long stock” because the risk / reward profile is nearly identical to long stock. Furthermore, if you remain in this position until expiration, you will probably wind up buying the stock at strike A one way or the other. If the stock is above strike A at expiration, it would make sense to exercise the call and buy the stock. If the stock is below strike A at expiration, you’ll most likely be assigned on the put and be required to buy the stock.

Since you’ll have the same risk / reward profile as long stock at expiration, you might be wondering, “Why would I want to run a combination instead of buying the stock?” The answer is leverage. You can achieve the same end without the up-front cost to buy the stock.

At initiation of the strategy, you will have some additional margin requirements in your account because of the short put, and you can also expect to pay a net debit to establish your position. But those costs will be fairly small relative to the price of the stock.

Most people who run a combination don’t intend to remain in the position until expiration, so they won’t wind up buying the stock. They’re simply doing it for the leverage.

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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, the long call will usually cost more than the short put. So the strategy will be established for a net debit. If the stock price is below strike A, you will usually receive more for the short put than you pay for the long call. So the strategy will be established for a net credit. Remember: The net debit paid or net credit received 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 be able to establish this strategy for a net credit. 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.

The Setup

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

Who Should Run It

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

Short Straddle

Profile Version / Simplified Version / Comprehensive Version

Short Straddle – Introduction

A Short Straddle, is a neutral option trading strategy that profits when a stock stays stagnant. This is the exact opposite of a Long Straddle which profits when the underlying stock moves strongly either to upside or downside. When you execute a Short Straddle, you are in fact selling (or “writing”) a Long Straddle to another party. In this sense, the person who bought the Straddle position that you sold, profits when the underlying stock moves strongly in either direction, whereas conversely, you profit when the underlying stock stays stagnant. As you are “Selling” or “Writing” a position, you make in profit the amount of money the buyer paid for the Straddle and that creates a net credit to your account. This is what we call a Credit Spread.

Find Options Strategies With Similar Risk Profiles

As a Long Straddle grants you unlimited profit when the underlying asset moves strongly in either direction, it also means that as a writer of a Short Straddle, you are exposed to unlimited loss when the underlying asset fails to stay stagnant. You can also redistribute the risk bias of a short straddle using a Short Strip Straddle or a Short Strap Straddle.

When To Use Short Straddle?

One should use a short straddle when one is of the opinion that an underlying stock will stay sideways until option expiration.

How To Use Short Straddle?

Establishing a short straddle simply involves the simultaneous writing (sell to open) of a call option and a put option on the underlying asset, at the same strike price and expiration date.

This establishes a short call option and a short put option. A short call option allows you to profit when the underlying asset is sideways or down and a short put option allows you to profit when the underlying asset is sideways or up. Combine them both and you will have a short straddle which profits when the underlying asset stays stagnant or within a tight range.

If you are already holding long or short stock position, you could also create the short straddle synthetically, known as the Synthetic Short Straddle, without closing your existing stock position.

Short Straddle Example

Assuming QQQQ at $44. Sell To Open QQQQ Jan44Call, Sell To Open QQQQ Jan44Put

Trading Level Required For Short Straddle

A Level 5 options trading account that allows the execution of writing naked options is needed for the Short Straddle. Read more about Options Account Trading Levels.

Profit Potential of Short Straddle :

The Short Straddle reaches maximum profit when both short call and put options expire during expiration. This happens when the underlying asset closes right on the strike price of both legs during expiration. However, even if the underlying stock is slightly up or down during expiration, the option that is In The Money do not gain enough to nullify the value on the expired option, the position still results in a net profit. This upper and lower point where the in the money option gains the exact value of the expire option is called the Upper and Lower Breakeven point.

Profit Calculation of Short Straddle:

Max. Return = Net Credit
% Return = Net Credit ч [(Option Strike Price + Highest Option Bid) – Net Credit]

Following up on the above example, assuming QQQQ at $44 at expiration.
Sold the JAN 44 Call for $2.20
Sold the JAN 44 Put for $2.00

Max Profit = $2.20 + $2.00 = $4.20

% Return = $4.20 ч [(44 + 2.20) – $4.20] = 10% profit

Risk / Reward of Short Straddle:

Maximum Profit: Limited
Net Credit Received

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Maximum Loss: Unlimited

Break Even Point of Short Straddle:

There are 2 break even points to a short straddle. In this case, a breakeven point is the point from which the position will start to make a loss. One breakeven point if the underlying asset goes up (Upper Breakeven), and one breakeven point if the underlying asset goes down (Lower Breakeven).

Upper BEP: Strike Price + Net Credit
Lower BEP: Strike Price – Net Credit

Following up on the above example,
Upper Break Even = Strike Price + Net Credit = $44.00 + $4.20 = $48.20
Lower Break Even = Strike Price – Net Credit = $44.00 – $4.20 = $39.80

Advantages Of Short Straddle :

:: Able to profit when stock do not move.

:: An initial credit is received on the transaction so the investor does not have to put up any money to enter into the position.

Disadvantages Of Short Straddle:

:: There will be more commissions involved than simply writing naked call or put options.

:: The loss potential is unlimited. That means that you can lose as much money as the underlying stock can move.

:: The profit potential is limited to the net credit recieved and nothing more.

:: The margin requirements for this strategy are fairly high.

Adjustments for Short Straddles Before Expiration :

1. If the underlying asset is expected to fluctuate within a slightly wider range than expected, the position can be closed in favor of a short strangle position.

2. If the underlying asset moves strongly in one direction, you should buy back the In the Money option quickly in order to limited losses.

Short Put Synthetic Straddle Explained

Consider the simplest option strategy, the long call. When you buy a call, your loss is limited to the premium paid, while your possible gain is unlimited. Now consider the purchase of a put and its underlying stock. Again, your loss is limited to the premium paid for the put plus any out-of-the-money amount, and your profit potential is unlimited as the stock price increases. Below is a graph that compares these two positions:

Position Synthetic Position
Long Call Long Put/Long Stock
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 Two Calls
Short Straddle Long Stock/Short Two Calls

Put/Call parity can differ only by trivial amounts such as trading costs. If parity is violated, an opportunity for arbitrage exists. While you may never get the chance to execute an arbitrage trade, it is important to understand them and their importance in the options pricing mechanism.

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