THE OPTIONS COURSE- LONG SYNTHETIC STRADDLES

THE OPTIONS COURSE


LONG SYNTHETIC STRADDLES

One of my favorite delta neutral strategies is the long synthetic straddle. It can be especially profitable because you can make adjustments as the market moves to increase your return. In this kind of straddle, you are combining options with stock; and as the market moves up or down, you can make money both ways. Perhaps this seems like a magic trick, especially if you are short stock and long calls. Obviously one leg of the trade will lose money as the other makes a profit. The difference between the profit and loss determines how much you are going to be able to pocket in profits with certain types of positions. 

Many factors govern the amount of profit, including the size of your account, the size of the trade, and whether you can adjust the trade to put yourself back to delta neutral after the market makes a move. So, to review, there are at least three good reasons that a trader might prefer a synthetic straddle position as opposed to simply buying or selling stock outright.

1. The synthetic position is less costly, either in cash or margin requirements.

2. A synthetic position actually improves some element(s) of the base position that you are looking to enter.

3. The synthetic position will permit easier adjustments to the trade as conditions change.

In all, the synthetic straddle is a very powerful trading vehicle. When we account for costs of carry, put and call synthetic straddles are identical and can be used interchangeably. Stockholders and short sellers alike will be able to adjust the risk picture of a directional stock position to a delta neutral position, thus giving them the opportunity to make money in either direction.

Example : Long Synthetic Straddle Using Puts

Let’s set up a long synthetic straddle by going long 100 shares of XYZ at $50 a share and long two September XYZ 50 puts with three months until expiration at $2.50 a contract.  In this trade, when the market goes up, you have a profit on the stock and a smaller loss on the options (because their delta decreased). This leaves a net profit. When the market goes down, you have a loss on the underlying asset against a bigger profit on the options (because their delta increased), so again you have a net profit. 

Either way, when the market moves you can make additional profits by adjusting the trade back to delta neutral. The risk is due to the time decay of the options. Risk on this example is the cost of the options, or $500: (2 × $2.50) × 100 = $500. Total risk is assumed only if you hold the position to expiration and the underlying asset does not move (or you fall asleep and never make an adjustment). The maximum profit is unlimited. The upside breakeven of a long synthetic straddle is calculated by adding the net debit paid for the options to the price of the underlying asset. 


FIGURE  Long Synthetic Straddle (Using Long Puts) Risk Graph

In this case, the upside breakeven is 55: (50 + 5 = 55). The downside breakeven is a little trickier. It is calculated using the following equation: [(2 × option strike price) – price of underlying stock at initiation] – net debit of options. In this trade, the downside breakeven is $45: [(2 × 50) – 50] – 5 = $45. Thus, this trade makes money if the price of the underlying moves above $55 a share or below $45, assuming you make no adjustments on the trade. Long synthetic straddles are best employed when you expect a significant move in the price of the underlying in either direction.

Exiting the Position

Let’s investigate exit strategies for the long synthetic straddle with puts:

• XYZ falls below the downside breakeven (45): If the stock’s price falls below the downside breakeven, you can exercise one of the puts to mitigate the loss on the stock and sell the other long put for a profit.

• XYZ falls within the downside (45) and upside (55) breakevens: This is the range of risk and will cause you to consider closing out the entire position at a loss or selling just the put options. The maximum risk is the cost of the double premium or $500 paid out for the puts.

• XYZ rises above the upside breakeven (55): If the stock’s price rises above the upside breakeven, you will be making money on the stock and losing money on the put options. You can sell the stock to garner the profit and either sell the puts at a loss or hold onto them in case of a reversal.

Long Synthetic Straddle Using Puts Case Study

In this example, we want to find a stock or market that has been trading quietly, but could make an explosive move higher or lower. Studying the chart of the PHLX Semiconductor Index ($SOX) in April 2003, we arrive at the conclusion that the chip index is due for an explosive move in the near future. We are not sure of the direction and decide to set up a delta neutral strategy. However, it is not possible to set up a synthetic straddle on the Semiconductor Index. Why? It’s a cash index. Instead, we decide to implement this trade on the Semiconductor HOLDRS (SMH), which is an exchange-traded fund that holds a basket of semiconductor stocks.

Holding Company Depositary Receipts (HOLDRS) are exchange-traded funds that hold baskets of stocks from specific industry groups. HOLDRS trade on the American Stock Exchange and can be bought or sold in lots of 100 shares. For example, investors can buy or sell Biotechnology HOLDRS (BBH), Semiconductor HOLDRS (SMH), or Oil Service HOLDRS (OIH). In all, the American Stock Exchange offers trading in 17 different HOLDRS. Options are also available on these exchange-traded funds and can be used to profit from trends related to specific sectors or industry groups. First, we notice that the SMH is trading for $26.50 a share during the month of April. 

We establish a long synthetic straddle by purchasing two near-the-money puts and 100 shares of Semiconductor HOLDRS. The near-the-money puts have a strike price of 25 and expire in January 2004. The put premium is initially $3.20 and the trade is entered for a net debit of $3,290. The SMH synthetic straddle will have a slightly bullish bias due to the fact that the put options are slightly out-of-the-money. The delta of one January 25 put at initiation is approximately 32. As a result, this position has a positive delta of roughly 36. We could make the position almost perfectly delta neutral by purchasing three January 25 puts. But for the purposes of illustration, let’s assume the trade is established using the aforementioned number of shares and contracts.

The maximum profit is unlimited to the upside as SMH moves higher. The maximum risk is limited and equal to the net debit, or $640 plus the difference in price between the SMH and the strike price multiplied by the number of shares, or $1.50 × 100. Therefore, the maximum risk is $790, but will occur only if the options are held until expiration. The upside breakeven is computed as the stock price plus the net debit of the options, or 32.90: (26.50 + 6.40). The downside breakeven is equal to 2 times the strike price minus the price of the stock minus the net debit of the options. In this case, 17.10: (50 – 26.50) – 6.40 = 17.10. Therefore, the trade requires a large move, above 32.90 or below 17.10, to earn a profit at expiration.

In all likelihood, the strategist would not hold this position until expiration because time decay is greatest 30 days before expiration. Let’s suppose instead, the trade was closed 60 days before expiration, or on November 21, 2003. How would this trade have fared? At the time the position was closed, the Semiconductor HOLDRS were well above the entry price and near $41 a share. The puts were deep out-of-the-money and practically worthless. The strategist could take the profits, which equal the value of the shares minus the cost of the trade, or $4,100 minus $3,290 or $810 (25 percent), and then hold onto the two put options as lottery tickets.


FIGURE  SMH Synthetic Straddle with Two Puts 

Example : Long Synthetic Straddle with Calls

You can also create a long synthetic straddle by selling short the stock and buying call options to create an overall delta neutral position. When the market goes up, you have a loss on the underlying asset, but again you have a bigger profit on the options (their delta increases). When the market goes down, you have a profit on the underlying stock and a smaller loss on the options (their delta decreases). Either way, as long as the market moves beyond the breakevens, the trade harvests a net profit. Both trades are placed in markets where a rise in volatility is anticipated and the stock and options are liquid—that is, they have a sufficient number of shares (or contracts) trading that there is no problem entering or exiting the trade.

Let’s examine a long synthetic straddle by shorting the stock and buying two September XYZ 50 calls @ 2.50 against XYZ trading at $50 per share. The maximum risk is limited to the net cost of the calls plus the difference in the call strike price minus the price of the stock at trade initiation. In this example, the maximum loss is limited to $500: [(2 × 2.50) + (50 – 50)] × 100 = $500. The reward is unlimited above the upside and below the downside breakevens. The downside breakeven is calculated by subtracting the net debit of the options from the stock price at trade initiation. 

In this example, the downside breakeven is 45: (50 – 5 = 45). The upside breakeven is calculated by adding net debit of the options to two times the strike price minus the initial stock price. In this example, the upside breakeven is 55: [(2 × 50) – 50] + 5 = 55. So, the trade theoretically will make a profit if the underlying rises above the upside breakeven (55) or falls below the downside breakeven (45). As you can see, this risk graph is identical in format to the put synthetic straddle. Both offer a visual look at the strategy’s unlimited reward beyond the upside and downside breakevens.


FIGURE  Long Synthetic Straddle (Using Long Calls) Risk Graph

Exiting the Position

Let’s investigate exit strategies for the long synthetic straddle:

• XYZ falls below the downside breakeven (45): If the stock’s price falls below the downside breakeven, you can purchase the shorted stock and let the calls expire worthless.

• XYZ falls within the downside (45) and upside (55) breakevens: This is the range of risk and will cause you to consider closing out the entire position at a loss or purchasing back the shorted stock and possibly holding the call options. The maximum risk for the entire position is the net cost of $500.

• XYZ rises above the upside breakeven (55): If the stock’s price rises above the upside breakeven, you will be making money on the call options faster than you are losing on the shorted stock. You can close out the shorted stock and one call option and hold the additional option for additional revenue.

Long Synthetic Straddle with Calls Case Study

In this example, we want to trade the oil service in anticipation of an explosive move higher or lower, but we are not sure about direction. This time, the underlying asset is the Oil Service HOLDRS (OIH), which is an exchange-traded fund that holds a basket of oil drilling companies. In April 2003, with the OIH trading for $56 a share, we initiate a synthetic straddle by purchasing two October 2003 55 calls for $5.70 and selling short 100 OIH shares. The trade is established for a credit equal to the difference between the short sale price minus the premium, or $4,460: (56 – 11.40) × 100. Success depends on the OIH making a move dramatically higher or lower. 

The upside breakeven is $65.40, or two times the strike price, minus the stock price, plus the options premium. The downside breakeven is simply the price paid for OIH minus the options premium, or $44.60. The maximum possible loss is $1,040, but will be incurred only if the trade is held until expiration. Just as in the other example of a long synthetic straddle using puts, the strategist will not want to hold this trade until expiration. Instead, we will exit the trade before the last 30 days, or during that period of time when time decay is at its greatest. So, let’s assume we exit the trade 45 days before the October calls expire. 


FIGURE  OIH Synthetic Straddle with Two Calls

In this case, on August 30, 2003, the OIH was trading for $60 a share and the two calls were each quoted for $6 a contract. So, the stock position resulted in a $4 per share loss, or $400, and the options moved only modestly higher. The strategist could book a $60 profit by closing out the long calls. So, time decay hurt this position. In the end, the trade lost $360. It needed a larger move in the underlying asset and perhaps more time to work in the strategist’s favor. Rather than closing the position entirely, the strategist could roll the position forward using longer-term options.

STRATEGY ROAD MAPS

Long Straddle Road Map

In order to place a long straddle, the following 14 guidelines should be observed:

1. Look for a market with low volatility about to experience a sharp increase in volatility that moves the stock price in either direction beyond one of the breakevens. The best long straddle opportunities are in markets that are experiencing price consolidation as they are often followed by a breakout. To find these consolidating markets, look through your charts for familiar ascending, descending, or symmetric triangles. As the stock price approaches the apex (point) of these triangles, they build up energy, much like a coiled spring. At some point this energy needs to be released and results in the price moving quickly. You don’t care in which direction because you are straddling!

2. Check to see if this stock has options available.

3. Review options premiums per expiration dates and strike prices.

4. Investigate implied volatility values to see if the options are overpriced or undervalued. Look for cheap options at the low end of their implied volatility range, priced at less than the volatility of the underlying stock.

5. Explore past price trends and liquidity by reviewing price and volume charts over the past year.

6. A long straddle is composed of the simultaneous purchase of an ATM call and an ATM put with the same expiration month.

7. Place straddles with at least 60 days until expiration. You can also use LEAPS except the premiums are often very high and would be profitable only with a very large movement in the underlying stock.

8. Determine which spread to place by calculating:
  • Limited Risk: The most that can be lost on the trade is the double premiums paid.
  • Unlimited Reward: Unlimited to the upside and limited to the downside (the underlying can only fall to zero).
  • Upside Breakeven: Calculated by adding the call strike price to the net debit paid.
  • Downside Breakeven: Calculated by subtracting the net debit from the put strike price.


9. Create a risk profile of the most promising option combination and graphically determine the trade’s feasibility. A long straddle will have a V-shaped risk profile showing unlimited reward above and limited profit to the downside.

10. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.

11. Make an exit plan before you place the trade. For example, exit the trade when you have a 50 percent profit at least 30 days prior to expiration on the options. If you have a winner, you do not want to see it become a loser. In this case, exit with a reasonable 50 percent gain. If not, then you should exit before the major amount of time decay occurs, which is during the option’s last 30 days. If you have a multiple contract position, you can also adjust the position back to a delta neutral to increase profit potential.

12. Contact your broker to buy and sell the chosen options. Place the trade as a limit order so that you limit the net debit of the trade.

13. Watch the market closely as it fluctuates. The profit on this strategy is unlimited—a loss occurs if the underlying stock closes between the breakeven points.

14. Choose an exit strategy based on the price movement of the underlying and fluctuations in the implied volatility of the options.
  • The underlying shares fall below the downside breakevenYou can close the put position for a profit. You can hold the worthless call for a possible stock reversal.
  • The underlying shares fall within the downside and upside breakevens: This is the range of risk and will cause you to close out the position at a loss. The maximum risk is equal to the double premiums paid.
  • The underlying shares rise above the upside breakeven: You are in your profit zone again and can close the call position for a profit. You can hold the worthless put for a possible stock reversal.


Long Strangle Road Map

In order to place a long strangle, the following 14 guidelines should be observed:

1. Look for a relatively stagnant market where you expect an explosion of volatility that moves the stock price in either direction beyond one of the breakevens. The best long strangle opportunities are in markets that are experiencing price consolidation because consolidating markets are often followed by breakouts.

2. Check to see if this stock has options available.

3. Review options premiums per expiration dates and strike prices.

4. Investigate implied volatility values to see if the options are overpriced or undervalued. Look for cheap options at the low end of their implied volatility range, priced at less than the volatility of the underlying stock.

5. Explore past price trends and liquidity by reviewing price and volume charts over the past year.

6. A long strangle is composed of the simultaneous purchase of an OTM call and an OTM put with the same expiration month.

7. Look at options with at least 60 days until expiration to give the trade enough time to move into the money.

8. Determine which spread to place by calculating:
  • Limited Risk: The most that can be lost on the trade is the double premiums paid for the options.
  • Unlimited Reward: Unlimited to the upside and limited to the downside (as the underlying can only fall to zero).
  • Upside Breakeven: Calculated by adding the call strike price to the net debit paid.
  • Downside Breakeven: Calculated by subtracting the net debit from the put strike price.


9. Create a risk profile of the most promising option combination and graphically determine the trade’s feasibility. A long strangle will have a U-shaped risk profile showing unlimited reward above the upside breakeven and limited profit below the downside breakeven.

10. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.

11. Make an exit plan before you place the trade. For example, exit the trade when you have a 50 percent profit or at least 30 days prior to expiration on the options. Exit with a reasonable 50 percent gain. If not, then you should exit before the major amount of time decay occurs, which occurs during the option’s last 30 days.

12. Contact your broker to buy and sell the chosen options. Place the trade as a limit order so that you limit the net debit of the trade.

13. Watch the market closely as it fluctuates. The profit on this strategy is unlimited—a loss occurs if the underlying stock closes at or below the breakeven points. You can also adjust the position back to a delta neutral to increase profit potential if you have a multiple contract position.

14. Choose an exit strategy based on the price movement of the underlying stock and fluctuations in the implied volatility of the options:
  • The underlying shares fall below the downside breakevenYou can close the put position for a profit. You can hold the worthless call for a possible stock reversal.
  • The underlying shares fall within the upside and downside breakevens: This is the range of risk and will cause you to close out the position at a loss. The maximum risk is limited to the premiums paid.
  • The underlying shares rise above the upside breakeven: You are in your profit zone again and can close the call position for a profit. You can hold the worthless put for a possible stock reversal.


Long Synthetic Straddle Road Map

In order to place a long synthetic straddle with puts or calls, the following 14 guidelines should be observed:

1. Look for a market with low volatility about to experience a sharp increase in volatility that moves the stock price in either direction beyond one of the breakevens. The best long synthetic straddle opportunities are in markets that are experiencing price consolidation as they are often followed by a breakout.

2. Check to see if this stock has options available.

3. Review options premiums per expiration dates and strike prices.

4. Investigate implied volatility values to see if the options are overpriced or undervalued. Look for cheap options. Those are options that are at the low end of their implied volatility range, priced at less than the volatility of the underlying stock.

5. Explore past price trends and liquidity by reviewing price and volume charts over the past year.

6. A long synthetic straddle can be composed by going long two ATM put options per long 100 shares or by purchasing two ATM call options against 100 short shares. Either technique creates a delta neutral trade that can be adjusted to bring in additional profit when the market moves up or down.

7. Place synthetic straddles using options with at least 60 days until expiration. You can also use LEAPS except the premiums are often very high and may be profitable only with a very large movement in the underlying stock.

8. Determine which spread to place by calculating:
  • Limited Risk: For a long synthetic straddle using puts, add the net debit of the options to the stock price at initiation minus the option strike price and then multiply this number by the number of shares. For a long synthetic straddle using calls, add the net debit of the options to the option strike price minus the price of the underlying at trade initiation, and then multiply this number by the number of shares. This is assumed only if you hold the position to expiration and the underlying stock closes at the option strike price.
  • Unlimited Reward: Unlimited to the upside and limited to the downside (as the underlying can only fall to zero).
  • Upside Breakeven: Calculated by adding the price of the underlying stock at initiation to the net debit of the options.
  • Downside Breakeven: Calculated by subtracting the stock purchase price plus the double premium paid for the options from twice the option strike price.


9. Create a risk profile of the most promising option combination and graphically determine the trade’s feasibility. A long synthetic straddle will have a U-shaped risk profile, showing unlimited reward and limited risk between the breakevens.

10. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.

11. Make an exit plan before you place the trade. For example, exit the trade when you have a 50 percent profit at least 30 days prior to expiration on the options. If not, then you should exit before the major amount of time decay occurs, which is during the option’s last 30 days. You can also adjust the position back to a delta neutral to increase profit potential depending on how many contracts you are trading.

12. Contact your broker to buy and sell the chosen options. Place the trade as a limit order so that you limit the net debit of the trade.

13. Watch the market closely as it fluctuates. The profit on this strategy is unlimited—a loss occurs if the underlying stock closes between the breakeven points.

14. Choose an exit strategy based on the price movement of the underlying shares and fluctuations in the implied volatility of the options. Exiting the long synthetic straddle with puts:
  • The underlying shares fall below the downside breakevenIf the stock’s price falls below the downside breakeven, you can exercise one of the puts to mitigate the loss on the stock and sell the other put for a profit.
  • The underlying shares fall within the downside and upside breakevens: This is the range of risk and will cause you to consider closing out the entire position at a loss or selling just the put options. The maximum risk is the cost of the double premium paid out for the puts.
  • The underlying shares rise above the upside breakevenIf the stock’s price rises above the upside breakeven, you will be making money on the stock and losing money on the put options. You can sell them at a loss or hold onto them in case of a reversal. Exiting the long synthetic straddle with calls:
  • The underlying shares fall below the downside breakevenIf the stock’s price falls below the downside breakeven, you can purchase the shorted stock and let the calls expire worthless.
  • The underlying shares fall within the downside and upside breakevens: This is the range of risk and will cause you to consider closing out the entire position at a loss or purchasing back the shorted stock and possibly holding the call options.
  • The underlying shares rise above the upside breakevenIf the stock’s price rises above the upside breakeven, you will be making money on the call options faster than you are losing on the shorted stock. You can close out the shorted stock and one call option and hold the additional option for additional revenue.


CONCLUSION

Every trader, no matter how new or experienced, has wished they had bought the opposite side of a trade at one time or another. Maybe we felt strongly about earnings for a company and found out that though the news was good, the stock fell on the actual report. There are several different technical patterns that signal a strong move is likely, but the direction is hard to predict. Fortunately, there are a number of option strategies—straddles, strangles, and synthetic straddles— that take advantage of large moves without the need to predict market direction. A straddle is a delta neutral strategy that is made up of buying an ATM call and an ATM put.  A strangle is similar but uses OTM options instead. 

The obvious question new traders have is how do these types of trades make money? Any price movement means either a call value gain and a put loss, or a put gain and a call loss. However, the delta will increase more on the side of the trade that gains than it will decrease on the side that is losing value. The other way we profit in a straddle is if implied volatility increases for the options. Since we are buying both sides of the trade, a rise in IV will benefit both the put and the call. However, this can also work in reverse, so we need to be confident that IV will either rise or at least stay constant. IV increases on pending news events, like earnings or FDA decisions. 

However, once the news has been announced, IV usually implodes and can lead to a volatility crush. A straddle is a limited risk/unlimited reward strategy, but traders should still set profit goals. Many straddle traders look to make 50 percent profit on a straddle, but might use adjustments to lower risk, while holding on for higher profits. For example, once one side of a straddle pays for the whole trade, we can sell this side and hold on for a gain in the other side of the straddle. Of course, this would be contingent on the belief the stock was about to reverse course. The strategist purchases straddles and strangles when there are expectations that the stock will make a significant move higher or lower, but the direction is uncertain. 

A sideways-moving stock will result in losses to the straddle or strangle holder. However, although a stock needs to make a rather large move to make a profit on a straddle (or a strangle), we also can get out without much of a loss if the stock doesn’t move within a given time frame. However, this is only the case if we purchase options with enough time left until expiration. Time decay is the biggest enemy we have with a straddle, and time decay picks up speed the last 30 days of an option’s life. A long synthetic straddle consists of long stock and long puts or short stock and long calls to create a delta neutral trade. Most of the time, a long synthetic straddle utilizes at-the-money (ATM) options. Remember, ATM options normally have a delta near 50, or in this case –50. 

However, the maximum risk is not the entire debit, just the cost of the options. Risk occurs if the stock does not move by expiration and the time value of the long options erodes away. The benefit to trading a long synthetic straddle is the adjustments that can be made. As the stock moves up and down, we can adjust the trade back to delta neutral to lock in profits. Many traders make adjustments when the total delta of the trade is up or down 100. We can make these adjustments by selling or buying stock or by selling or buying the options. This strategy is a great long-term tool, but make sure you understand the risks before entering this type of trade.

However, it is important to understand the basic rules and to know the associated risks. As with any strategy, a risk graph should always be created before entering the trade. When you put on a long synthetic straddle, you are placing a hedge trade. All you are paying for is the cost of the options. If your broker requires you to have margin on the stock side, then try to find someone who will give you a cross-margin account. There are companies out there that offer cross margining, although it is a relatively new concept to the public. Putting on a synthetic straddle is not new; just the concept of looking at it as a low-risk trade from the brokerage firm side is new.

These trades are referred to as synthetic primarily because the two ATM options behave like the underlying stock (two ATM options = +100 or –100 deltas). They create a synthetic instrument that moves as the underlying asset changes. When you initiate the position, you are completely offsetting the other side to create a perfect delta neutral trade. As the market moves, you will gain more on the winning side of the trade or in adjustment profits than you will relinquish on the losing portions of the trade. It works because you are combining a fixed delta with a variable delta. Adjustments can be made when the market makes a move. If the market moves so that the overall trade is +100 deltas, then you can sell short 100 shares of stock. 

If the market moves and the overall position delta becomes –100, you can buy another futures contract or 100 shares of stock. Either way, the trade returns to delta neutral. As a beginner, you should play it safe and place trades that offer limited risk. Although it may be tempting to go short options since a sale places money directly in your trading account over time, I do not recommend selling options until you are truly well-versed in delta neutral trading. Remember that when you sell options you do get a credit, but you only earn this credit as the options lose value over time.

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