The purpose of a synthetic long straddle is to replicate the profit/loss profile of a traditional long straddle. There are two ways to do that: either by using puts or calls. Choosing one over the other is simply a matter of assessing one’s existing positions and/or outlook.
Let’s have a closer look at the synthetic long call straddle, examine its component parts and determine under which circumstances it might best be employed.
How Is it Made?
Whereas a long straddle is composed of the purchase of an at-the-money call and an at-the-money put, a synthetic long straddle (using calls) consists of:
- The short sale of 100 shares of the underlying stock; and
- The purchase of two at-the-money calls (per 100 shares shorted).
It should be noted that most options traders would not go the “synthetic” route when initiating a long straddle position. Rather, the synthetic long call straddle is more suited as a backup role for a trader whose short sale is already in danger, or one who’s worried about the prospects of an upcoming bullish move in the underlying security.
Let’s look at a real-life example to better illustrate the strategy.
Imagine that after a steep fall for Citigroup (NYSE: C), you determine that the goose is cooked for both the financial sector and the company itself. In the first week of January your research urges you to short 100 shares at exactly $50.00 (red circle).
For the next three weeks you’re sitting on a nice little profit.
But before long, the sector begins to recover, and you watch as Citigroup starts retracing all its lost ground. You also begin to wonder if reports of an imminent bullish move for the stock have any substance.
By the time the shares return to your entry point at $50.00, you realize the jig is up, and you immediately initiate a synthetic long call strategy (blue circle). You purchase two at-the-money May 50 calls for $2.00 each and fall back into your 18th century, George III high-back leather chair with a sigh of relief.
With the synthetic straddle in place, you’re safe in both directions. If the stock resumes its downward course, the calls will expire worthless, and you’ll profit from the short sale. But if the rumors are true, and Citigroup climbs to, say, $60, your short sale will be underwater $1,000, but the two call options will be in the money $10 each. That’s a $2,000 gain, less your initial premium of $400, so you’re sitting on a win of $600 ($2000 – $1,000 – $400).
Your maximum loss with a synthetic long straddle is limited to the initial premium spent on the calls – in this case, $400. That would occur if the stock ended up at exactly $50 at expiration. Both calls would expire worthless and there would be no profit from the short. You’d just be out the expense of the options.
As it turns out, expiry brought the stock to $54.25 (black circle). The short sale was negative $425 at that point, while the two calls fetched a collective $850. Total gain on the liquidation of all positions is $25 ($850 – $425 – $400). A whole lot better than the alternative.
A synthetic long call straddle is an appropriate strategy to employ as a “repair” for a short stock position gone awry – particularly if one expects a big move to ensue in the underlying before expiration. It has limited risk and unlimited reward potential.
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