Execute A Long Call Synthetic Straddle

Introduction To Long Call Synthetic Straddle

Execute A Long call synthetic straddle

A long call synthetic straddle is the re-engineering of the long straddle strategy and payoff by shorting shares and buying at the money calls. A long straddle, however, involves just the buying of at the money puts and an equal number of at the money calls. The payoff between a long call synthetic straddle and a long straddle is similar.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook: Anticipate Increased Volatility
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Limited loss potential
Step 7 : Loss calculation
Step 8 : Potential for unlimited profit
Step 9 : Profit calculation
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade: Executing a long call synthetic straddle
Step 12 : Exit Trade: Exiting the long call synthetic straddle
Step 13 : Record Trade In Diary

 

Step 1 : Perform economic, fundamental and technical analysis

Perform economic analysis, fundamental analysis and technical analysis to determine volatility. For example, perhaps an upcoming earnings announcement or an interest rate announcement will cause a particular sector to be highly volatile. Look out for events that will cause the underlying security to be volatile. Also, look out for large swings in price on the charts when these events occur. In other words, do some backtesting and find out how an underlying security reacts to an announcement. However, it is essential to execute the long call straddle in a period of low volatility so that the call options are not overpriced. Some chart patterns to look out for are:

Read: Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis

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Step 2 : Outlook : Anticipate Increased Volatility

The trader that executes a long call synthetic straddle is anticipating increased volatility levels.If the price of the underlying security makes significant moves upwards or downwards in a manner that justifies the costs to initiate the long call synthetic straddle, the trader could earn a profit. The interesting thing about a long call synthetic straddle or a long straddle is that it does not matter whether the price of the underlying security goes up or down but as long as the price move is significant, a profit may be realisable. This is evident in the way the payoff diagram is drawn, a “V” shaped curve.

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Step 3 : Study the option chain

Examine the option chain available.Select contracts which give the trade enough time to perform. Since buying call options is part of a synthetic long call, be mindful that the options are subject to time value erosion. Do not use options with an expiry that is 30 days out unless you are absolutely sure that there will be a huge movement in price that will more than offset time value erosion in such a way that the trade is profitable.

Read: Learn to read and understand options chain

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Step 4 : Breakeven Analysis

There is an upside breakeven point and a downside breakeven point where there is neither profit nor loss. The downside breakeven point is:

Underlying security’s short sale price – net debit

The upside breakeven point is:

Call exercise price + net debit

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Step 5: Understand Your Profit Zones

Execute A Long call synthetic straddle

After performing breakeven analysis, an options trader should understand that the trade is profitable only if the price of the underlying security is in the profit zones.

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Step 6 : Limited loss potential

The long call synthetic straddle is a “V” shaped curve. As such, it has a minimum point at which a maximum loss occurs. This maximum loss occurs when the underlying security’s price is equal to the strike price of the options used. At this price point, there is no loss or profit on the short stock position while the options expire worthless. At this price point, the maximum that a trader can lose is equal to the net debit. The net debit is the amount of money paid for the options.

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Step 7 : Loss calculation

The maximum loss is the net debit. However, in the real world, traders have to take into account the brokerage commissions charged to them. Hence, the maximum loss can be calculated as:

Net debit + commissions paid to broker

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Step 8 : Potential for unlimited profit

The curve for a long call synthetic straddle is “V” shaped. Due to the way it is structured, a significant profit could be realised whether the price of the underlying security goes up or down. The condition is this: The price of the underlying security must move beyond and above the upper breakeven point or below the lower breakeven point in order for a profit to be realisable.

The price of the underlying security could potentially move to $0. At a price point of $0, a certain level of profit is realised and the profit increase further at this point. This is evident be cause the curve eventually intersects the vertical axis.

The price of the underlying security however could go up infinitely. If there is a major catalyst  in the way of the selling of corporate assets and the announcement of a dividend hike and an increase of the earnings per share of the company, the price of the underlying security could make a significant move upwards. Since there is no limit to how high the price of the underlying security can move up to, there is also no limit to the profits attainable.

Mathematically, the conditions under which profitability is achieved are:

  • Underlying security’s price > Call exercise price + net debit
  • Underlying security’s price < Put exercise price – net debit

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Step 9 : Profit calculation

The profit is dependent on the underlying security’s price at that point in time. The breakeven points can be calculated once the trade has been initiated. When the trade is initiated, the exercise price is known and the net debit represents the total option premium paid to acquire the options.

The profit can be calculated as:

Underlying security’s price – call exercise price – net debit

This formula is to be used when the price of the underlying security moves upwards.

Underlying security’s short sale price – underlying security’s price – net debit

This formula is to be used when the price of the underlying security moves downwards.

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Step 10 : Calculate Risk & Reward Ratio

Next calculate the risk and reward ratio for the trade. Ensure that the risk and reward ratio is attractive before executing the trade. This in itself is subjective and a very wide topic. Do read: Understanding Risk/Reward Ratio For Option Traders

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Step 11 : Set Up Trade : Executing a long call synthetic straddle

A long call synthetic straddle can be executed by:

  • Shorting 100 shares
  • Long 2 at the money(ATM) calls

The ratio is a short sale of 100 shares to 2 long ATM calls. This ratio is to be adhered to for the payoff diagram to be similar to that of the long call straddle.

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Step 12 : Exit Trade : Exiting the long call synthetic straddle

  1. If the price of the underlying security falls below the lower breakeven point, the options trader can consider buying to close the shorted stock and holding onto the calls. The calls could profit from a price move to the upside if there is sufficient time value remaining. If the entire trade was liquidated at prices below the lower breakeven point, the trade would have been profitable.
  2. If the price of the underlying security trades between the upper and lower breakeven points, the trade is loss making on paper. The entire trade can be closed at a loss. Or, the shorted stock can be bought back leaving the calls that has the possibility of profiting from any price moves to the upside.
  3. If the price of the underlying security trades above the upper breakeven point, the profit realisable on the calls is greater than the absolute loss realisable on the short stock. As a result, the trade will be profitable if liquidated entirely. The option trader can choose to close the shorted stock position and 1 call option leaving 1 option to profit from any potential price moves to the upside.

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Step 13 : Record Trade In Diary

After the long call synthetic straddle is exited, profit and loss should be recorded. Analyse the trade to find out what went wrong or what was done right. Apply that experience to other trades in the future.

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Example Of A Long Call Synthetic Straddle

The price of ABC Corp is currently trading at a price of $70. A trader anticipates that there will be a significant price movement in the underlying security. However, he is unsure of the direction of the price movement. An example of an instance where the price of the underlying security could move either direction is earnings announcement event. Events such as the earnings announcements could disappoint or surprise investors. If the earnings has far exceeded the expectations of the analysts, the “surprise” will cause the price of the underlying security to move up significantly. Sometimes, when it is a disappointment to investors, the price of the underlying security will move down significantly.

The trader executes a long call synthetic straddle by:

  • Shorting 100 shares at a price of $70
  • Buying 2 Dec 70 calls @ $1.50 each

As a result, there is a net debit of :

($1.50 x 2) x 100 = $300

If the price of the ABC Corp trades at $70:

Beginning value Ending value Loss(-) or Profit(+)
Short 100 shares $70 $70 $0
Long 2 Dec 70 calls $1.50 $0 -$3
Overall loss per share -$3

The total loss in this instance is :

$3 x 100 = $300

If the price of ABC Corp trades at $100:

Beginning value Ending value Loss(-) or Profit(+)
Short 100 shares $70 $100 -$30
Long 2 Dec 70 calls $1.50 $30 +$28.50
Overall profit per share 28.50 x 2 – 30

= 27

The total profit is thus:

$27 x 100 = $2700

If the price of ABC Corp trades at $30:

Beginning value Ending value Loss(-) or Profit(+)
Short 100 shares $70 $30 +$40
Long 2 Dec 70 calls $1.50 $0 -$1.50
Overall profit per share $40 – $1.50 x 2

= $37

The total profit is thus:

$37 x 100 = $3700

Similarities in payoff of long call synthetic straddle, long call straddle, long put synthetic straddle, strip & strap

The long call synthetic straddle is most similar to the long straddle, the strip and the strap. These options strategies should be investigated before a decision on the strategy to use.

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