Long Put Synthetic Straddle Explained

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 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.

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.

Long Straddle (Buy Straddle) Options Trading Strategy Explained

Published on Thursday, April 19, 2020 | Modified on Wednesday, June 5, 2020

LOOKING FOR A SHARE BROKER?

We can help you find the right broker.

Long Straddle (Buy Straddle) Options Strategy

The Long Straddle (or Buy Straddle) is a neutral strategy. This strategy involves simultaneously buying a call and a put option of the same underlying asset, same strike price and same expire date.

A Long Straddle strategy is used in case of highly volatile market scenarios wherein you expect a big movement in the price of the underlying but are not sure of the direction. Such scenarios arise when company declare results, budget, war-like situation etc.

This is an unlimited profit and limited risk strategy. The profit earns in this strategy is unlimited. Higher volatility results in higher profits. The maximum loss is limited to the net premium paid. The max loss occurs when underlying asset price on expire remains at the strike price.

The usual Long Straddle Strategy looks like as below for NIFTY current index value at 10400 (NIFTY Spot Price):

Suppose Nifty is currently at 10400 and due to some upcoming events you expect the price to move sharply but are unsure about the direction. In such a scenario, you can execute long strangle strategy by buying Nifty Put at 10400 and buying Nifty Call at 10400. The net premium paid will be your maximum loss while the profit will depend on how high or low the index moves.

When to use Long Straddle (Buy Straddle) strategy?

The strategy is perfect to use when there is market volatility expected due to results, elections, budget, policy change, war etc.

Example

Example 1 – Stock Options:

Let’s take a simple example of a stock trading at в‚№40 (spot price) in June. The option contracts for this stock are available at the premium of:

• July 40 Put – в‚№2
• July 40 Call – в‚№2

Lot size: 100 shares in 1 lot

1. Buy ‘July 40 Put’: 100*1 = 200
2. Buy ‘July 40 Call’: 100*1 = 200

Net Debit: в‚№200 + в‚№200 = в‚№400

Now let’s discuss the possible scenarios:

Scenario 1: Stock price remains unchanged at в‚№40

• July 40 Put – Expires worthless
• July 40 Call – Expires worthless
• Net Debit was в‚№400 initially paid to take the position.
• Total Loss = в‚№400

The total loss of в‚№400 is also the maximum loss in this strategy.

Scenario 2: Stock price goes above в‚№50

• July 40 Put – Expires worthless
• July 40 Call Expires in-the-money with an intrinsic value of (50-40)*100 = в‚№1000
• Net Debit was в‚№400 initially paid to take the position.
• Total Profit = в‚№1000 – в‚№400 = в‚№600

Scenario 3: Stock price goes down to в‚№30

• July 40 Put Expires in-the-money with an intrinsic value of (40-30)*100 = в‚№1000
• July 40 Call – Expires worthless
• Net Debit was в‚№400 initially paid to take the position.
• Total Profit = в‚№1000 – в‚№400 = в‚№600

Example 2 – Bank Nifty

Market View – Neutral

When you are not sure on the direction the underlying would move but are expecting the rise in its volatility.

Actions

• Buy Call Option
• Buy Put Option

Breakeven Point

2 break-even points

A straddle has two break-even points.

Lower Breakeven = Strike Price of Put – Net Premium

Upper breakeven = Strike Price of Call + Net Premium

Risk Profile of Long Straddle (Buy Straddle)

Limited

The maximum loss for long straddle strategy is limited to the net premium paid. It happens the price of underlying is equal to strike price of options.

Maximum Loss = Net Premium Paid

Reward Profile of Long Straddle (Buy Straddle)

Unlimited

There is unlimited profit opportunity in this strategy irrespective of the direction of the underlying. Profit occurs when the price of the underlying is greater than strike price of long Put or lesser than strike price of long Call.

Max Profit Scenario of Long Straddle (Buy Straddle)

Max profit is achieved when at one option is exercised.

Max Loss Scenario of Long Straddle (Buy Straddle)

When both options are not exercised. This happens when underlying asset price on expire remains at the strike price.

Advantage of Long Straddle (Buy Straddle)

Earns you unlimited profit in a volatile market while minimizing the loss.

Disadvantage of Long Straddle (Buy Straddle)

The price change has to be bigger to make good profits.

How to exit?

• Sell the Call Options
• Sell the Put Options

Simillar Strategies

Save 60% to 90% on Brokerage Fee

We can help you save over 60% in brokerage.

Comments

No comments found. Be the first to post a comment.

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.