Short Call Synthetic Straddle Explained

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Short Call Synthetic Straddle

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

Short Call Synthetic Straddle Construction
Sell 2 ATM Calls
Long 100 Shares

Short call synthetic straddles are limited profit, unlimited risk options trading strategies that are used when the options trader feels that the underlying asset price will experience very little volatility in the near future.

Limited Profit Potential

Maximum profit for the short call synthetic straddle is achieved when the underlying stock price on expiration date is trading at the strike price of the options sold. At this price, both written options expire worthless and the options trader gets to keep the entire net premium received taken as profit.

The formula for calculating maximum profit is given below:

  • Max Profit = Net Premium Received – Commissions Paid
  • Max Profit Achieved When Price of Underlying = Strike Price of Short Call

Unlimited Risk

Large losses for the short call synthetic straddle can be sustained when the underlying stock price makes a strong move either upwards or downwards at expiration. A strong upward move will cause the uncovered short call to expire deep in the money while a strong downward move will cause the long stock position to suffer a serious loss.

The formula for calculating loss is given below:

  • Maximum Loss = Unlimited
  • Loss Occurs When Price of Underlying > Strike Price of Short Call + Net Premium Received OR Price of Underlying

Breakeven Point(s)

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

  • Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
  • Lower Breakeven Point = Purchase Price of Underlying – Net Premium Received

Example

Suppose XYZ stock is trading at $40 in June. An options trader implements a short call synthetic straddle by selling two JUL 40 calls for $200 each and buying 100 shares of XYZ stock for $4000. The net premium received for the calls is $400.

If XYZ stock is trading at $50 on expiration in July, the two JUL 40 calls expire in-the-money and has an intrinsic value of $1000 each. Buying back the the call options to close out the position will cost the trader $2000. However, the long stock position posted a gain of $1000. Taking into account the net premium of $400 received, the short call synthetic straddle’s loss comes to: $2000 – $1000 – $400 = $600.

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On expiration in July, if XYZ stock is still trading at $40, both the JUL 40 calls expire worthless while the long stock position broke even. Hence, the short call synthetic straddle trader made his maximum profit which is equal to the initial $400 net premium received upon entering the trade.

Note: While we have covered the use of this strategy with reference to stock options, the short call 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 short call synthetic straddle in that they are also low volatility strategies that have limited profit potential and unlimited risk.

Short Call

What Is a Short Call?

A short call option position in which the writer does not own an equivalent position in the underlying security represented by their option contracts. Making a short call is an options trading strategy in which the trader is betting that the price of the asset on which they are placing the option is going to drop.

How Does a Short Call Work?

A short call strategy is one of two simple ways options traders can take bearish positions. It involves selling call options, or calls. Calls give the holder of the option the right to buy an underlying security at a specified price.

If the price of the underlying security falls, a short call strategy profits. If the price rises, there’s unlimited exposure during the length of time the option is viable, which is known as a naked short call. To limit losses, some traders will exercise a short call while owning the underlying security, which is known as a covered call.

Real World Example of a Short Call

Say Liquid Trading Co. decides to sell calls on shares of Humbucker Holdings to Paper Trading Co. The stock is trading near $100 a share and is in a strong uptrend. However, the Liquid group believes Humbucker is overvalued, and based on a combination of fundamental and technical reasons, they believe it eventually will fall to $50 a share. Liquid agrees to sell 100 calls at $110 a share. This gives Paper the right to purchase Humbucker shares at that specific price.

Selling the call option allows Liquid to collect a premium upfront; that is, Paper pays liquid $11,000 (100 x $110). If the stock heads lower over time, as the Liquid gang thinks it will, Liquid profits on the difference between what they received and the price of the stock. Say Humbucker stock does drop to $50. Then Liquid reaps a profit of $6,000 ($11,000 – $5,000).

Things can go awry, however, if Humbucker shares continue to climb, creating limitless risk for Liquid. For example, say the shares continue their uptrend and go to $200 within a few months. If Liquid executes a naked call, Paper can execute the option and purchase stock worth $20,000 for $11,000, resulting in a $9,000 trading loss for Liquid.

If the stock were to rise to $350 before the option expires, Paper could purchase stock worth $35,000 for the same $11,000, resulting in a $24,000 loss for Liquid.

Short Calls Versus Long Puts

As previously mentioned, a short call strategy is one of two common bearish trading strategies. The other is buying put options or puts. Put options give the holder the right to sell a security at a certain price within a specific time frame. Going long on puts, as traders say, is also a bet that prices will fall, but the strategy works differently.

Say Liquid Trading Co. still believes Humbucker stock is headed for a fall, but it opts to buy 100 $110 Humbucker puts instead. To do so, the Liquid group must put up the $11,000 ($110 x 100) in cash for the option. Liquid now has the right to force Paper, who is on the other side of the deal, to buy the stock at this price – even if Humbucker shares drop to Liquid’s projected $50 a share. If they do, Liquid has made a tidy profit – $6,000.

In a way, it’s achieving the same goal, just through the opposite route. Of course, the long put does require that Liquid shell out funds upfront. The advantage is that unlike the short call, the most Liquid can lose is $11,000, or the total price of the option.

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.

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