Long Call Synthetic Straddle Explained

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Long Put Synthetic Straddle

The long put synthetic straddle recreates the long straddle strategy by buying the underlying stock and buying enough at-the-money puts to cover twice the number of shares purchased. That is, for every 100 shares bought, 2 put contracts must be bought.

Long Put Synthetic Straddle Construction
Buy 2 ATM Puts
Long 100 Shares

Long put synthetic straddles are unlimited profit, limited risk options trading strategies that are used when the options trader feels that the underlying asset price will experience significant volatility in the near future.

Unlimited Profit Potential

Large gains are made with the long put syntethic straddle when the underlying asset price makes a sizable move either upwards or downwards at expiration.

The formula for calculating profit is given below:

  • Maximum Profit = Unlimited
  • Profit Achieved When Price of Underlying > Purchase Price of Underlying + Net Premium Paid OR Price of Underlying

Limited Risk

Maximum loss for the long put synthetic straddle occurs when the underlying asset price on expiration date is trading at the strike price of the put options purchased. At this price, both options expire worthless, while the long stock position achieved breakeven. Hence, a maximum loss equals to the net premium paid is incurred by the options trader.

The formula for calculating maximum loss is given below:

  • Max Loss = Net Premium Paid + Commissions Paid
  • Max Loss Occurs When Price of Underlying = Strike Price of Long Put

Breakeven Point(s)

There are 2 break-even points for the long put synthetic straddle position. The breakeven points can be calculated using the following formulae.

  • Upper Breakeven Point = Purchase Price of Underlying + Net Premium Paid
  • Lower Breakeven Point = Strike Price of Long Put – Net Premium Paid

Example

Suppose XYZ stock is trading at $40 in June. An options trader executes a long put synthetic straddle by buying two JUL 40 puts for $200 each and buying 100 shares of XYZ stock for $4000. The net premium paid for the puts is $400.

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If XYZ stock plunges to $30 on expiration in July, the two JUL 40 puts expire in-the-money and has an intrinsic value of $1000 each. Selling the put options will net the trader $2000. However, the long stock position suffers a loss of $1000. Subtracting the initial premium paid of $400, the long put synthetic straddle’s profit comes to $600.

On expiration in July, if XYZ stock is still trading at $40, both the JUL 40 put options expire worthless while the long stock position broke even. Hence, the long put synthetic straddle suffers a maximum loss which is equal to the initial net premium paid of $400 taken to enter the trade.

Long Call Synthetic Straddle

The synthetic straddle can also be implemented using calls instead of puts and that strategy is known as the long call synthetic straddle.

Note: While we have covered the use of this strategy with reference to stock options, the long put synthetic straddle is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the long put synthetic straddle in that they are also high volatility strategies that have unlimited profit potential and limited risk.

Understanding Synthetic Options

Options are touted as one of the most common ways to profit from market swings. Whether you are interested in trading futures, currencies or want to buy shares of a corporation, options offer a low-cost way to make an investment with less capital.

While options have the ability to limit a trader’s total investment, options also expose traders to volatility, risk, and adverse opportunity cost. Given these limitations, a synthetic option may be the best choice when making exploratory trades or establishing trading positions.

Key Takeaways

  • A synthetic option is a way to recreate the payoff and risk profile of a particular option using combinations of the underlying instrument and different options.
  • A synthetic call is created by a long position in the underlying combined with a long position in an at-the-money put option.
  • A synthetic put is created by a short position in the underlying combined wit a long position in an at-the-money call option.
  • Synthetic options are viable due to put-call parity in options pricing.

Options Overview

There is no question that options have the ability to limit investment risk. If an option costs $500, the maximum that can be lost is $500. A defining principle of an option is its ability to provide an unlimited opportunity for profit with limited risk.

However, this safety net comes with a cost because many studies indicate the vast majority of options held until expiration expire worthless. Faced with these sobering statistics, it is difficult for a trader to feel comfortable buying and holding an option for too long.

Options “Greeks” complicate this risk equation. The Greeks—delta, gamma, vega, theta, and rho—measure different levels of risk in an option. Each one of the Greeks adds a different level of complexity to the decision-making process. The Greeks are designed to assess the various levels of volatility, time decay and the underlying asset in relation to the option. The Greeks make choosing the right option a difficult task because there is the constant fear that you are paying too much or that the option will lose value before you have a chance to gain profits.

Finally, purchasing any type of option is a mixture of guesswork and forecasting. There is a talent in understanding what makes one option strike price better than another strike price. Once a strike price is chosen, it is a definitive financial commitment and the trader must assume the underlying asset will reach the strike price and exceed it to book a profit. If the wrong strike price is chosen, the entire strategy will most likely fail. This can be quite frustrating, particularly when a trader is right about the market’s direction but picks the wrong strike price.

Synthetic Options

Many problems can be minimized or eliminated when a trader uses a synthetic option instead of purchasing a vanilla option. A synthetic option is less affected by the problem of options expiring worthless; in fact, adverse statistics can work in a synthetic’s favor because volatility, decay and strike price play a less important role in its ultimate outcome.

There are two types of synthetic options: synthetic calls and synthetic puts. Both types require a cash or futures position combined with an option. The cash or futures position is the primary position and the option is the protective position. Being long in the cash or futures position and purchasing a put option is known as a synthetic call. A short cash or futures position combined with the purchase of a call option is known as a synthetic put.

A synthetic call lets a trader put on a long futures contract at a special spread margin rate. It is important to note that most clearing firms consider synthetic positions less risky than outright futures positions and therefore require a lower margin. In fact, there can be a margin discount of 50% or more, depending on volatility.

A synthetic call or put mimics the unlimited profit potential and limited loss of a regular put or call option without the restriction of having to pick a strike price. At the same time, synthetic positions are able to curb the unlimited risk that a cash or futures position has when traded without offsetting risk. Essentially, a synthetic option has the ability to give traders the best of both worlds while diminishing some of the pain.

How a Synthetic Call Works

A synthetic call, also referred to as a synthetic long call, begins with an investor buying and holding shares. The investor also purchases an at-the-money put option on the same stock to protect against depreciation in the stock’s price. Most investors think this strategy can be considered similar to an insurance policy against the stock dropping precipitously during the duration that they hold the shares.

How a Synthetic Put Works

A synthetic put is an options strategy that combines a short stock position with a long call option on that same stock to mimic a long put option. It is also called a synthetic long put. Essentially, an investor who has a short position in a stock purchases an at-the-money call option on that same stock. This action is taken to protect against appreciation in the stock’s price. A synthetic put is also known as a married call or protective call.

Disadvantages of Synthetic Options

While synthetic options have superior qualities compared to regular options, that doesn’t mean that they don’t generate their own set of problems.

If the market begins to move against a cash or futures position it is losing money in real time. With the protective option in place, the hope is that the option will move up in value at the same speed to cover the losses. This is best accomplished with an at-the-money option but they are more expensive than an out-of-the-money option. In turn, this can have an adverse effect on the amount of capital committed to a trade.

Even with an at-the-money option protecting against losses, the trader must have a money management strategy to determine when to get out of the cash or futures position. Without a plan to limit losses, he or she can miss an opportunity to switch a losing synthetic position to a profitable one.

Also, if the market has little to no activity, the at-the-money option can begin to lose value due to time decay.

Example of a Synthetic Call

Assume the price of corn is at $5.60 and market sentiment has a long side bias. You have two choices: you can purchase the futures position and put up $1,350 in margin or buy a call for $3,000. While the outright futures contract requires less than the call option, you’ll have unlimited exposure to risk. The call option can limit risk but is $3,000 is a fair price to pay for an at-the-money option and, if the market starts to move down, how much of the premium will be lost and how quickly will it be lost?

Let’s assume a $1,000 margin discount in this example. This special margin rate allows traders to put on a long futures contract for only $300. A protective put can then be purchased for only $2,000 and the cost of the synthetic call position becomes $2,300. Compare this to the $3,000 for a call option alone, booking is an immediate $700 savings.

Put-Call Parity

The reason that synthetic options are possible is due to the concept of put-call parity implicit in options pricing models. Put-call parity is a principle that defines the relationship between the price of put options and call options of the same class, that is, with the same underlying asset, strike price, and expiration date.

Put-call parity states that simultaneously holding a short put and long European call of the same class will deliver the same return as holding one forward contract on the same underlying asset, with the same expiration, and a forward price equal to the option’s strike price. If the prices of the put and call options diverge so that this relationship does not hold, an arbitrage opportunity exists, meaning that sophisticated traders can theoretically earn a risk-free profit. Such opportunities are uncommon and short-lived in liquid markets.

The equation expressing put-call parity is:

The Bottom Line

It’s refreshing to participate in options trading without having to sift through a lot of information in order to make a decision. When done right, synthetic options have the ability to do just that: simplify decisions, make trading less expensive and help to manage positions more effectively.

Long straddle

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To profit from a big price change – either up or down – in the underlying stock.

Explanation

Example of long straddle

Buy 1 XYZ 100 call at (3.30)
Buy 1 XYZ 100 put at (3.20)
Net cost = (6.50)

A long straddle consists of one long call and one long put. Both options have the same underlying stock, the same strike price and the same expiration date. A long straddle is established for a net debit (or net cost) and profits if the underlying stock rises above the upper break-even point or falls below the lower break-even point. Profit potential is unlimited on the upside and substantial on the downside. Potential loss is limited to the total cost of the straddle plus commissions.

Maximum profit

Profit potential is unlimited on the upside, because the stock price can rise indefinitely. On the downside, profit potential is substantial, because the stock price can fall to zero.

Maximum risk

Potential loss is limited to the total cost of the straddle plus commissions, and a loss of this amount is realized if the position is held to expiration and both options expire worthless. Both options will expire worthless if the stock price is exactly equal to the strike price at expiration.

Breakeven stock price at expiration

There are two potential break-even points:

  1. Strike price plus total premium:
    In this example: 100.00 + 6.50 = 106.50
  2. Strike price minus total premium:
    In this example: 100.00 – 6.50 = 93.50

Profit/Loss diagram and table: long straddle

Long 1 100 call at (3.30)
Long 1 100 put at (3.20)
Net cost = (6.50)
Stock Price at Expiration Long 100 Call Profit/(Loss) at Expiration Long 100 Put Profit/(Loss) at Expiration Long Straddle Profit / (Loss) at Expiration
110 +6.70 (3.20) +3.50
109 +5.70 (3.20) +2.50
108 +4.70 (3.20) +1.50
107 +3.70 (3.20) +0.50
106 +2.70 (3.20) (0.50)
105 +1.70 (3.20) (1.50)
104 +0.70 (3.20) (2.50)
103 (0.30) (3.20) (3.50)
102 (1.30) (3.20) (4.50)
101 (2.30) (3.20) (5.50)
100 (3.30) (3.20) (6.50)
99 (3.30) (2.20) (5.50)
98 (3.30) (1.20) (4.50)
97 (3.30) (0.20) (3.50)
96 (3.30) +0.80 (2.50)
95 (3.30) +1.80 (1.50)
94 (3.30) +2.80 (0.50)
93 (3.30) +3.80 +0.50
92 (3.30) +4.80 +1.50
91 (3.30) +5.80 +2.50
90 (3.30) +6.80 +3.50

Appropriate market forecast

A long straddle profits when the price of the underlying stock rises above the upper breakeven point or falls below the lower breakeven point. The ideal forecast, therefore, is for a “big stock price change when the direction of the change could be either up or down.” In the language of options, this is known as “high volatility.”

Strategy discussion

A long – or purchased – straddle is the strategy of choice when the forecast is for a big stock price change but the direction of the change is uncertain. Straddles are often purchased before earnings reports, before new product introductions and before FDA announcements. These are typical of situations in which “good news” could send a stock price sharply higher, or “bad news” could send a stock price sharply lower. The risk is that the announcement does not cause a significant change in stock price and, as a result, both the call price and put price decrease as traders sell both options.

It is important to remember that the prices of calls and puts – and therefore the prices of straddles – contain the consensus opinion of options market participants as to how much the stock price will move prior to expiration. This means that buyers of straddles believe that the market consensus is “too low” and that the stock price will move beyond a breakeven point – either up or down.

The same logic applies to options prices before earnings reports and other such announcements. Dates of announcements of important information are generally publicized in advanced and well-known in the marketplace. Furthermore, such announcements are likely, but not guaranteed, to cause the stock price to change dramatically. As a result, prices of calls, puts and straddles frequently rise prior to such announcements. In the language of options, this is known as an “increase in implied volatility.”

An increase in implied volatility increases the risk of trading options. Buyers of options have to pay higher prices and therefore risk more. For buyers of straddles, higher options prices mean that breakeven points are farther apart and that the underlying stock price has to move further to achieve breakeven. Sellers of straddles also face increased risk, because higher volatility means that there is a greater probability of a big stock price change and, therefore, a greater probability that an option seller will incur a loss.

“Buying a straddle” is intuitively appealing, because “you can make money if the stock price moves up or down.” The reality is that the market is often “efficient,” which means that prices of straddles frequently are an accurate gauge of how much a stock price is likely to move prior to expiration. This means that buying a straddle, like all trading decisions, is subjective and requires good timing for both the buy decision and the sell decision.

Impact of stock price change

When the stock price is at or near the strike price of the straddle, the positive delta of the call and negative delta of the put very nearly offset each other. Thus, for small changes in stock price near the strike price, the price of a straddle does not change very much. This means that a straddle has a “near-zero delta.” Delta estimates how much an option price will change as the stock price changes.

However, if the stock price “rises fast enough” or “falls fast enough,” then the straddle rises in price. This happens because, as the stock price rises, the call rises in price more than the put falls in price. Also, as the stock price falls, the put rises in price more than the call falls. In the language of options, this is known as “positive gamma.” Gamma estimates how much the delta of a position changes as the stock price changes. Positive gamma means that the delta of a position changes in the same direction as the change in price of the underlying stock. As the stock price rises, the net delta of a straddle becomes more and more positive, because the delta of the long call becomes more and more positive and the delta of the put goes to zero. Similarly, as the stock price falls, the net delta of a straddle becomes more and more negative, because the delta of the long put becomes more and more negative and the delta of the call goes to zero.

Impact of change in volatility

Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices – and straddle prices – tend to rise if other factors such as stock price and time to expiration remain constant. Therefore, when volatility increases, long straddles increase in price and make money. When volatility falls, long straddles decrease in price and lose money. In the language of options, this is known as “positive vega.” Vega estimates how much an option price changes as the level of volatility changes and other factors are unchanged, and positive vega means that a position profits when volatility rises and loses when volatility falls.

Impact of time

The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion, or time decay. Since long straddles consist of two long options, the sensitivity to time erosion is higher than for single-option positions. Long straddles tend to lose money rapidly as time passes and the stock price does not change.

Risk of early assignment

Owners of options have control over when an option is exercised. Since a long straddle consists of one long, or owned, call and one long put, there is no risk of early assignment.

Potential position created at expiration

There are three possible outcomes at expiration. The stock price can be at the strike price of a long straddle, above it or below it.

If the stock price is at the strike price of a long straddle at expiration, then both the call and the put expire worthless and no stock position is created.

If the stock price is above the strike price at expiration, the put expires worthless, the long call is exercised, stock is purchased at the strike price and a long stock position is created. If a long stock position is not wanted, the call must be sold prior to expiration.

If the stock price is below the strike price at expiration, the call expires worthless, the long put is exercised, stock is sold at the strike price and a short stock position is created. If a short stock position is not wanted, the put must be sold prior to expiration.

Note: options are automatically exercised at expiration if they are one cent ($0.01) in the money. Therefore, if the stock price is “close” to the strike price as expiration approaches, and if the owner of a straddle wants to avoid having a stock position, the long straddle must be sold prior to expiration.

Other considerations

Long straddles are often compared to long strangles, and traders frequently debate which the “better” strategy is.

Long straddles involve buying a call and put with the same strike price. For example, buy a 100 Call and buy a 100 Put. Long strangles, however, involve buying a call with a higher strike price and buying a put with a lower strike price. For example, buy a 105 Call and buy a 95 Put.

Neither strategy is “better” in an absolute sense. There are tradeoffs.

There are three advantages and two disadvantages of a long straddle. The first advantage is that the breakeven points are closer together for a straddle than for a comparable strangle. Second, there is less of a change of losing 100% of the cost of a straddle if it is held to expiration. Third, long straddles are less sensitive to time decay than long strangles. Thus, when there is little or no stock price movement, a long straddle will experience a lower percentage loss over a given time period than a comparable strangle. The first disadvantage of a long straddle is that the cost and maximum risk of one straddle (one call and one put) are greater than for one strangle. Second, for a given amount of capital, fewer straddles can be purchased.

The long strangle two advantages and three disadvantages. The first advantage is that the cost and maximum risk of one strangle are lower than for one straddle. Second, for a given amount of capital, more strangles can be purchased. The first disadvantage is that the breakeven points for a strangle are further apart than for a comparable straddle. Second, there is a greater chance of losing 100% of the cost of a strangle if it is held to expiration. Third, long strangles are more sensitive to time decay than long straddles. Thus, when there is little or no stock price movement, a long strangle will experience a greater percentage loss over a given time period than a comparable straddle.

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