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.
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:
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:
There are 2 break-even points for the short 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 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.
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.
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 short call synthetic straddle in that they are also low volatility strategies that have limited profit potential and unlimited risk.
The synthetic short straddle can also be implemented using puts instead of calls and that strategy is known as the short put synthetic straddle.
Since the short straddle can be synthetically constructed, similarly, the long straddle can be recreated using the long call synthetic straddle strategy. Long call synthetic straddles are used when the underlying stock price is perceived to be highly volatile.
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