Short Call Synthetic Straddle : Profit From Low Volatility

Introduction To Short Call Synthetic Straddle

Short call synthetic straddle

The short call synthetic straddle has an inverted “V” shaped curve which implies that it has a capped profit and unlimited loss potential. It’s payoff profile is similar to that of a short straddle.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Unlimited loss
Step 7 : Short Call Synthetic Straddle Loss Calculation
Step 8 : Capped profit
Step 9 : Profit calculation For Short Call Synthetic Straddle
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade : Executing a short call synthetic straddle
Step 12 : Exit Trade & Record Trade In Diary

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Step 1 : Perform economic, fundamental and technical analysis

It is important to have an overview of the economy by performing economic analysis. Also, fundamental and technical analysis should also be performed. This is necessary because it is essential to know and anticipate that little volatility is to be experienced over the life of the short call synthetic straddle.

Some suggested 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

The trader who executes a short call synthetic straddle anticipates little to no volatility in the price of the underlying security. When that happens, the trader stands a greater chance of earning a profit. Since the shape of the payoff curve is an inverted “V” shape, the maximum profit occurs at only 1 price point, that is, the exercise(strike) price of the calls.

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Step 3 : Study the option chain

Examine the options chain and select the options to be used in the short call synthetic straddle.

Read: Learn to read and understand options chain

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Step 4 : Breakeven Analysis

The downside breakeven point is:

Underlying security’s acquisition price – net credit

The upside breakeven point is:

Call exercise(strike) price + net credit

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Step 5: Understand Your Profit Zones

Short call synthetic straddle

After the breakeven points are calculated, the trader is able to understand where the profit zones are.

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Step 6: Unlimited loss

As the price of the underlying security moves above the upside breakeven point or below the downside breakeven point, a loss is realisable. While profits are limited to the net credit, the losses are unlimited.

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Step 7: Short Call Synthetic Straddle Loss Calculation

The loss can be calculated as:

Underlying security’s price – Call exercise(strike) price – net credit

The formula above is to be used when the price of the underlying security increases beyond the upside breakeven point.

Underlying security’s acquisition price – trading price of underlying security – net credit

The formula above is to be used when the underlying security’s price moves below the breakeven point.

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Step 8: Capped profit

The profit in a short call synthetic straddle, much like a short straddle, is capped and limited. The maximum profit occurs when the price of the underlying security is equal to the strike price of the call options. At that price point, the options will expire worthless and the long stock will breakeven without profit or loss. As a result, the trader gets to keep the net credit as profit.

For a profit to be realisable, the price of the underlying security must trade between the downside and the upside breakeven points.

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Step 9: Profit calculation For Short Call Synthetic Straddle

The maximum profit can be calculated as :

Net credit – commissions paid to broker

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Step 10 : Calculate Risk & Reward Ratio

Next calculate the estimated risk and reward ratio based on entry and potential exit prices. This will help a trader compare the trade to another of a similar nature.

Read more: Understanding Risk/Reward Ratio For Option Traders

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Step 11: Set Up TTrade: Executing a short call synthetic straddle

A trader will execute a short call synthetic straddle by:

  • Buying 100 shares in the underlying security
  • Writing 2 at the money(ATM) calls on the same underlying security

For every 100 shares bought in the underlying security, the trader will write 2 at the money call options on the same underlying security. The above ratio is to be adhered to.

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Step 12 : Exit Trade & Record Trade In Diary

Lastly, exit the trade and record the trade’s performance in a diary or a journal. Reflect on the trade to become a better trader.

Example Of A Short Call Synthetic Straddle

The price of TTT Corp is trading at $50. A trader anticipates little volatility in the security and decides to execute a short call synthetic straddle by:

  • writing 2 Dec 50 calls @ $2 each
  • buying 100 shares at a price of $50

If the price of TTT trades at $50:

Beginning value Ending value Profit(+) or Loss(-)
Write 2 Dec 50 calls $2 $0 +$4
Long 100 shares $50 $50 $0
Overall profit per share +$4

The total profit is thus:

$4 x 100 = $400

This is also the maximum profit as the price of the underlying security is equal to the call exercise(strike) price.

If the price of TTT trades at $70:

Beginning value Ending value Profit(+) or Loss(-)
Write 2 Dec 50 calls $2 $20 -$36
Long 100 shares $50 $70 +$20
Overall loss per share -$16

The total loss is thus:

$16 x 100 = $1600

If the price of TTT trades at $30:

Beginning value Ending value Profit(+) or Loss(-)
Write 2 Dec 50 calls $2 $0 +$4
Long 100 shares $50 $30 -$20
Overall loss per share -$16

The total loss when the price of TTT is at $30 is thus:

$16 x 100 = $1600

Comparable Strategies

For comparable strategies, one should read Short put synthetic straddle and Uncovered straddle/Short straddle/Sell straddle . These strategies have a similar payoff profile to the short call synthetic straddle.