Mastering Derivatives: Understanding synthetic straddle

Creating “synthetics” in the options market is not uncommon. This week, we look at how to create a synthetic straddle and when to optimally use this strategy.

Taking profits

A straddle refers to a position carrying a long call and a long put of the same strike with the same expiry date on an underlying. A straddle is typically a bet that the volatility of an underlying will explode. Therefore, a straddle is best set up before a macro-level event such as the Union Budget or the general elections. A synthetic straddle, however, has different characteristics.

• Mastering Derivatives: Salvaging losses with long puts or short futures?

Suppose you are long on two contracts of calls on an underlying, and the underlying has since moved up and there is still time for expiry of the options. But you are concerned that the uptrend will pause. This could lead to decline in the option price because of time decay. Or worse yet, what if the underlying turns and erodes some of your unrealised gains? Of course, you could take profits on your call options. Or if you want to continue your position, you can consider shorting the stock. This is set up to indirectly take profits on your call option. Importantly, the position converts from a long call to a synthetic straddle. How?

Note that a synthetic put is equal to a long call and a short stock. This comes from the put-call parity argument, where a long call and a long bond (which is the present value of the call strike) is equal to a long put and a long stock. Rearranging this equation, you can easily arrive at a long put being equal to a long call and a short stock, ignoring the bond. This means you can either buy a put or create a long put position synthetically by going long on a call and short on the stock. Therefore, combining two long calls with a short stock is equal to one long call and a synthetic put, which is why the position is referred to as a synthetic straddle.

• Mastering Derivatives: When counterparties make money 

Now, what happens to the synthetic straddle if the underlying continues to move up? The calls will generate gains. How? You have two call positions. So, one long call will offset losses from the short stock, while the other long call will generate gains through intrinsic value. But what if the underlying declines from the current level? Your long calls will lose value, but your short stock will generate gains, if the stock moves below your selling price less the cost of the long calls.  

What it is

Combining two long calls with a short stock is equal to one long call and a synthetic put

Optional reading

It is important not to initiate a position as a synthetic straddle. This set up works well if you already have a long call position and then convert it into a synthetic straddle. Note that by doing so, you would have converted your bullish position into one that is direction-neutral. That is, the position will gain whether the underlying moves up or down.

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