Introduction To Long Put Synthetic Straddle

The long put synthetic straddle is a strategy that imitates the payoff profile of a long straddle. As its name suggest, it is constructed with put options. The payoff profile is an unlimited potential profit strategy with a limited loss as evident by a “V” shaped curve.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook Assessment – Anticipating Volatility
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Capped loss
Step 7 : Loss calculation of a long put synthetic straddle
Step 8 : Potential for unlimited profit
Step 9: Profit calculation of a long put synthetic straddle
Step 10 : Calculate the risk and reward ratio
Step 11 : Executing a long put synthetic straddle
Step 12 : Exit trade and record trade in a diary

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Step 1 : Perform economic, fundamental and technical analysis

It is essential for the options trader to conduct some analysis to determine the direction of the markets and the underlying security if any. Some of the chart patterns traders should look out for are:

 

 

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

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Step 2 : Outlook Assessment – Anticipating Volatility

The “V” shaped curve which represents the payoff of the long put synthetic straddle suggests that a significant price move of the underlying security is a desirable outcome as it would lead to a sizeable profit. Hence, a trader who has executed a long put synthetic straddle is anticipating increased volatility levels

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Step 3 :Study the option chain

Study the options chain and select the options to be used in the construction of a long put synthetic straddle.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

After which,  the trader should perform breakeven analysis. The breakeven points should be calculated at this point.There is an upside breakeven point and a downside breakeven point. The downside breakeven point is:

Put exercise price – net debit

The upside breakeven point is:

Acquisition price of underlying security + net debit

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Step 5: Understand Your Profit Zones

After the breakeven points are calculated, understand that the profit zones are to the right and left of the breakeven points.

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Step 6 : Capped loss

The potential loss is limited to the net debit paid to initiate the long put synthetic straddle position. The lowest point on the “V” shaped curve represents the price point and the corresponding maximum loss of the long put synthetic straddle.

The maximum loss occurs when the price of the underlying security is equal to the exercise price of the put options.

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Step 7 : Loss calculation of a long put synthetic straddle

The loss can be calculated as :

Net debit + commissions paid to the broker

Traders pay brokerage fees to establish their trades. Hence, the above formula takes into account the brokerage commissions paid to the broker.

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Step 8 : Potential for unlimited profit

As long as the underlying security’s price makes a move above the upside breakeven point or below the downside breakeven point, a profit is realisable. The price of the underlying security can move to $0 or it can move up infinitely. To the downside, the profit is capped. But to the upside, there is no limit to the profit attainable.

The conditions under which profit is attainable:

• Underlying security’s price must be greater than the upside breakeven point
• Underlying security’s price must be less than the downside breakeven point

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Step 9: Profit calculation of a long put synthetic straddle

The profit can be calculated as:

Underlying security’s price – net debit – acquisition price of underlying security

The above formula can be used when the price of the underlying security moves up.

The profit can also be calculated as:

Put exercise price – net debit – underlying security’s price

The above formula is to be used when the price of the underlying security moves downwards

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Step 10 : Calculate the risk and reward ratio

At this point, the trader should calculate the potential risk and reward ratio. For more, read:Understanding Risk/Reward Ratio For Option Traders

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Step 11 : Executing a long put synthetic straddle

A long put synthetic straddle can be executed by:

• Buying 100 shares in the underlying security
• Buying 2 at the money puts on the same underlying security

The ratio is thus 2 long ATM puts for every 100 shares purchased.

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Step 12 : Exit trade and record trade in a diary

After the trade has been exited, the details of the trade should be recorded in a diary for reflection. This can help a trader sharpen his skills over time.

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Example

The price of XYZ Corp is trading at a price of $70. A trader anticipates significant volatility in the near term and intends to profit from it. However, he is unable to predict the direction of the price move of XYZ. He executes a long put synthetic straddle by:

• Buying 100 shares of XYZ at $70
• Buying 2 Dec 70 puts @ $1.75 each

If the price of XYZ stays constant at $70:

 Beginning valueEnding valueProfit(+) or Loss(-)Long 100 shares$70$70$0Long 2 Dec 70 puts$1.75$0-$3.50Overall loss per share  -$3.50

The total loss is thus:

$3.50 x 100 = $350

When the price stays constant and it equals the exercise price of the puts, a maximum loss occurs because the options expire worthless and the long stock position attains breakeven at $70( the strike price of the put)

Hence, $350 is the maximum loss without the inclusion of brokerage commissions.

If the price of XYZ trades at $100:

	Beginning value	Ending value	Profit(+) or Loss(-)
Long 100 shares	$70	$100	+$30
Long 2 Dec 70 puts	$1.75	$0	-$3.50
Overall loss per share			+$26.50

The total profit is:

$26.50 x 100 = $2650

If the price of XYZ trades at $40:

	Beginning value	Ending value	Profit(+) or Loss(-)
Long 100 shares	$70	$40	-$30
Long 2 Dec 70 puts	$1.75	$30	+$56.50
Overall loss per share			+$26.50

The total profit is:

$26.50 x 100 = $2650

As you can see, with significant price moves to the upside or downside, a profit is realisable.

Exiting a long put synthetic straddle

1. If the price of the underlying security trades at a price below the downside breakeven point, the options trader can consider exercising a put to mitigate the losses on the stock position. Next, he can sell the other put for a profit.
2. If the price of the underlying security trades between the upside and downside breakeven points, the trade is making a loss on paper. The option trader can consider closing out the entire position at a loss. Or, he could sell the put positions leaving the long stock position to profit from upside price moves.
3. If the price of the underlying security trades above the upside breakeven point, there will be profit in the long stock position but a loss on the put position. The options trader can liquidate the entire trade for a profit. Or, he could sell the stock and hold onto the puts for an anticipated reversal in prices.

Read: Execute A Long put: Profit from price movements to the downside

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