The long call synthetic straddle recreates the long straddle strategy by shorting the underlying stock and buying enough at-the-money calls to cover twice the number of shares shorted. That is, for every 100 shares shorted, 2 calls must be bought.
|Long Call Synthetic Straddle Construction|
|Buy 2 ATM Calls|
Short 100 Shares
Long call 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 term.
Large gains are made with the long call synthetic 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 loss for the long call syntethic straddle occurs when the underlying asset price on expiration date is trading at the strike price of the call options purchased. At this price, both options expire worthless, while the short 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:
There are 2 break-even points for the long call synthetic straddle position. The breakeven points can be calculated using the following formulae.
Suppose XYZ stock is trading at $40 in June. An options trader enters a long call synthetic straddle by buying two JUL 40 calls for $200 each and shorting 100 shares for $4000. The net premium paid 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. Selling the call options will net the trader $2000. However, the short stock position suffers a loss of $1000. Subtracting the initial debit of $400, the long call synthetic straddle trader's profit comes to $600.
On expiration in July, if XYZ stock is still trading at $40, both the JUL 40 calls expire worthless while the short stock position broke even. Hence, the long call synthetic straddle trader suffers a maximum loss which is equal to the initial net premium paid of $400 taken to enter the trade.
The synthetic straddle can also be implemented using long puts instead of long calls and that strategy is known as the long put synthetic straddle.
Note: While we have covered the use of this strategy with reference to stock options, the long call synthetic straddle is equally applicable using ETF options, index options as well as options on futures.
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).
The following strategies are similar to the long call synthetic straddle in that they are also high volatility strategies that have unlimited profit potential and limited risk.
Since the long straddle can be synthetically constructed, likewise, the short straddle can be recreated using the short call synthetic straddle strategy. Short call synthetic straddles are used when the underlying stock price is perceived to be non-volatile.
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