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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 Underlying |
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 < Purchase Price of Underlying - Net Premium Received
- Loss = Price of Underlying - Strike Price of Short Call - Net Premium Received OR Purchase Price of Underlying - Price of Underlying - Net Premium Received + Commissions Paid
Breakeven Point(s)
There are 2 break-even points for the short call synthetic straddle. 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.
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.
Short Put Synthetic Straddle
The synthetic short straddle can also be implemented using puts instead of calls and that strategy is known as the short put synthetic straddle.
Long Call 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.