Short Put Synthetic Straddle Explained

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Long Combination

AKA Synthetic Long Stock; Combo

The Strategy

Buying the call gives you the right to buy the stock at strike price A. Selling the put obligates you to buy the stock at strike price A if the option is assigned.

This strategy is often referred to as “synthetic long stock” because the risk / reward profile is nearly identical to long stock. Furthermore, if you remain in this position until expiration, you will probably wind up buying the stock at strike A one way or the other. If the stock is above strike A at expiration, it would make sense to exercise the call and buy the stock. If the stock is below strike A at expiration, you’ll most likely be assigned on the put and be required to buy the stock.

Since you’ll have the same risk / reward profile as long stock at expiration, you might be wondering, “Why would I want to run a combination instead of buying the stock?” The answer is leverage. You can achieve the same end without the up-front cost to buy the stock.

At initiation of the strategy, you will have some additional margin requirements in your account because of the short put, and you can also expect to pay a net debit to establish your position. But those costs will be fairly small relative to the price of the stock.

Most people who run a combination don’t intend to remain in the position until expiration, so they won’t wind up buying the stock. They’re simply doing it for the leverage.

Options Guy’s Tips

It’s important to note that the stock price will rarely be precisely at strike price A when you establish this strategy. If the stock price is above strike A, the long call will usually cost more than the short put. So the strategy will be established for a net debit. If the stock price is below strike A, you will usually receive more for the short put than you pay for the long call. So the strategy will be established for a net credit. Remember: The net debit paid or net credit received to establish this strategy will be affected by where the stock price is relative to the strike price.

Dividends and carry costs can also play a large role in this strategy. For instance, if a company that has never paid a dividend before suddenly announces it’s going to start paying one, it will affect call and put prices almost immediately. That’s because the stock price will be expected to drop by the amount of the dividend after the ex-dividend date. As a result, put prices will increase and call prices will decrease independently of stock price movement in anticipation of the dividend. If the cost of puts exceeds the price of calls, then you will be able to establish this strategy for a net credit. The moral of this story is: Dividends will affect whether or not you will be able to establish this strategy for a net credit instead of a net debit. So keep an eye out for them if you’re considering this strategy.

The Setup

  • Buy a call, strike price A
  • Sell a put, strike price A
  • The stock should be at or very near strike A

Who Should Run It

NOTE: The short put in this strategy creates substantial risk. That is why it is only for the most advanced option traders.

Short Put Synthetic Straddle Explained

Consider the simplest option strategy, the long call. When you buy a call, your loss is limited to the premium paid, while your possible gain is unlimited. Now consider the purchase of a put and its underlying stock. Again, your loss is limited to the premium paid for the put plus any out-of-the-money amount, and your profit potential is unlimited as the stock price increases. Below is a graph that compares these two positions:

Position Synthetic Position
Long Call Long Put/Long Stock
Long Put Long Call/Short Stock
Short Call Short Stock/Short Put
Short Put Long Stock/Short Call
Long Stock Long Call/Short Put
Short Stock Long Put/Short Call
Long Straddle Short Stock/Long Two Calls
Short Straddle Long Stock/Short Two Calls

Put/Call parity can differ only by trivial amounts such as trading costs. If parity is violated, an opportunity for arbitrage exists. While you may never get the chance to execute an arbitrage trade, it is important to understand them and their importance in the options pricing mechanism.

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Really Pretty Real: Understanding Synthetic Options Strategies, Pt 1

Learn how synthetic options strategies can help traders potentially lower transaction costs, improve price discovery, and more efficiently use capital.

Back before option pricing models and mathematical greeks—we’re talking delta, gamma, theta, vega, and rho, not the ancient Greeks (Socrates, Aristotle, Plato)—floor traders used synthetic positions to price options. Synthetics are positions that mimic the risk/reward profile of another position, typically using some combination of stock and options. Understanding synthetics gave those floor traders a strong foundation and deep knowledge of options. I want to help you gain the same insight into options strategies by explaining how to use and interpret synthetics.

Back in the day, floor traders used synthetic positions for arbitrage, which is a trading strategy that seeks to lock in a risk-free profit by buying one investment and simultaneously selling a similar or related investment at a different price. This arbitrage was available in the early days to options traders on the floors of the exchanges. But today, with the increase in computing power and brilliant PhDs coding algorithmic trading strategies, these arbitrage opportunities are difficult to come by for the remaining floor traders and for retail traders trading from their screens.

Nevertheless, understanding synthetics still offers the options trader several potential benefits:

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  1. They can help lower transaction costs
  2. They can help with efficient price discovery
  3. They can provide more efficient use of capital and flexibility

The Skinny on Synthetics

Before we get into the details of how these benefits work, let’s take a minute to relate synthetics to plain-vanilla options strategies. This is really quite simple. Ordinary options strategies with the same strike price and expiration month all have synthetic equivalents. And because of the relationship between calls, puts, and their respective underlying stocks, synthetics have profit/loss and risk profiles that are similar to regular options.

Option Position Synthetic Position
Long call Long put + long stock
Long call Long stock + long put
Long put Long call + short stock
Short call Short stock + short put
Short put Long stock + short call
Long stock Long call + short put
Short stock Long put + short call
Long straddle Short stock + long 2 calls
Short straddle Long stock + short 2 calls
Short put vertical Long call vertical: same strikes
Short call vertical Long put vertical: same strikes

Fewer Transaction Costs

Because of these relationships, synthetics can be used to express changing opinions about the direction of the market without closing out an existing plain-vanilla trade. By executing fewer trades, traders can potentially save on transaction costs. Let’s walk through some examples to see where the savings might come from.

Suppose a trader is already long a put, but he thinks the market might go higher and wants to get bullish, too. He could sell the put and buy a call, which would incur two commission fees. Or, he could buy the underlying stock and hold on to the put. That’s just one commission. This works because a long stock + long put on the same strike and month is equivalent to a long call.

Here’s another scenario. Suppose a trader is long a call and decides to get short the market. Instead of selling the call and buying a put, it might be cheaper to short the stock and hold the call. A long call + short stock on the same strike and month is equivalent to a long put.

What if a trader is unsure about direction, but wants to express an opinion about changing volatility?

Say the trader is long two calls. She’s unsure about which way the stock might move, but she thinks it could be a big move in a short time period. Maybe there’s an earnings announcement, court case, or some other binary event coming up. She could enter a long straddle to potentially profit from an increase in volatility. Instead of buying two puts, she could short the stock, because short stock + long two calls is equivalent to a long straddle.

Suppose a trader is short two calls and is unsure about direction, but he thinks the stock might experience a small move in the short term. He wants to enter a short straddle. Instead of shorting two puts, he could buy the stock. Long stock + short two calls is equivalent to a short straddle.

All clear yet? Synthetics can seem confusing, but they’re really just different ways of looking at—or possibly trading—a position with the same profit/loss and risk profile. We’ve seen how synthetics can potentially offer fewer transaction costs versus trading garden-variety options. In Part 2, we’ll look at how synthetics can offer a couple more benefits: efficient price discovery and efficient use of capital.

Spreads, Straddles, and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades.

Learn From an Options Trading Leader

Whether you’re an equity trader new to options trading or a seasoned veteran, TD Ameritrade can help you pursue options trading strategies.

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