Introduction To Short Put Synthetic Straddle
The short put synthetic straddle is made up of 100 shorted for every 2 at the money puts shorted. The short put synthetic straddle has a similar payoff profile to that of the short put straddle.
Steps
Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Anticipate Low Volatility
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Unlimited loss
Step 7 : Loss calculation of a short put synthetic straddle
Step 8 : Capped profit
Step 9 : Profit calculation of a short put synthetic straddle
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade – Executing a short put synthetic straddle
Step 12 : Exit Trade & Record Trade In Diary
Step 1 : Perform economic, fundamental and technical analysis
The options trader is looking for low volatility in the markets and the underlying security. To do this, he has to do economic and fundamental analysis. With fundamental analysis, the options trader may come to a conclusion that the price of the underlying security has very little upside and downside. Perhaps, the price of the underlying security is already fairly valued. The options trader must avoid events that cause spike in volatility levels. With regards to technical analysis, the trader is looking out for patterns of stagnation or chart patterns with very tight and narrow ranges. Suggested chart patterns to look out for are:
Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis
Step 2 : Outlook – Anticipate Low Volatility
The trader who executes a short put synthetic straddle is anticipating little to no volatility in the price of the underlying security. When that happens, there is a higher probability of the trade turning a profit. The payoff curve of a short put synthetic straddle is an inverted “V” shaped one. As such, the maximum profit is achieved at only 1 price point, the exercise or strike price of the puts involved.
Step 3 :Study the option chain
Examine the options chain. Select the options based on duration and strike price, to construct the short put synthetic straddle.
Read : Learn to read and understand options chain
Step 4 : Breakeven Analysis
The downside breakeven point is :
Put exercise or strike price – net credit
The upside breakeven point is:
Net credit + Short sale price of underlying security
Step 5: Understand Your Profit Zones
After the breakeven points are calculated, the options trader will know where the profit zone is. The profit zone is between the breakeven points.
Step 6 : Unlimited loss
A loss occurs when the price of the underlying security is trading above or below the breakeven points. The loss is unlimited due to the way the short put synthetic straddle is constructed – Short stock and short puts.
Step 7 : Loss calculation of a short put synthetic straddle
The loss can be calculated as:
Underlying security’s price – short sale price of underlying security – net credit
The formula above is to be used when the price of the security moves upwards.
The loss can also be calculated as:
Put exercise or strike price – underlying security’s price – net credit
The above formula is to be used when the price of the underlying security moves downwards.
Step 8 : Capped profit
Profit is limited for a short put synthetic straddle. The maximum profit occurs when the price of the underlying security is equal to the exercise or strike price of the put options on expiration date.
Step 9 : Profit calculation of a short put synthetic straddle
The maximum profit can be calculated as:
Net credit – commissions paid to broker
Step 10 : Calculate Risk & Reward Ratio
Since the risk of the short put synthetic straddle is unlimited, consider putting in place stop losses on the short put synthetic straddle. After this has been done, the options trader is able to calculate the risk and reward ratio, that is, the maximum potential reward for every dollar of risk taken. Do take note that for a short put synthetic straddle constructed with ATM puts, the maximum reward or profit occurs at only 1 price point.
Read more : Understanding Risk/Reward Ratio For Option Traders
Step 11 : Set Up Trade – Executing a short put synthetic straddle
A short put synthetic straddle can be executed by:
- Short 100 shares
- Write 2 at the money puts
The short sale price is equal to the exercise or strike price of the puts. The ratio above must be adhered to in order for the trade to be considered a short put synthetic straddle.
Step 12 : Exit Trade & Record Trade In Diary
After the trade has been exited, the trade’s performance should be recorded in a diary or a journal. The trader should conduct some personal reflection on the trade and compare his success or failure with trades of a similar nature. The trader should also find ways to improve on his personal trading algorithm.
Example Of A Short Put Synthetic Straddle
RRR Corp is trading at a price of $60. A trader foresees little volatility in the stock and decides to execute a short put synthetic straddle by shorting 100 shares at a price of $60 and writing 2 Dec 60 puts at a price of $1.50 each.
As a result, the net credit is:
$1.50 x 2 = $3
If the price of RRR Corp trades at $60 on expiration of the options:
| Beginning value | Ending value | Profit(+) or Loss(-) | |
| Short 100 shares | $60 | $60 | $0 |
| Short 2 Dec 60 puts | $1.50 | $0 | +$3 |
| Overall profit per share | +$3 |
The total profit in this instance is:
$3 x 100 = $300
The net credit is thus the maximum profit as well.
If there is a significant price swing to $100 on expiration:
| Beginning value | Ending value | Profit(+) or Loss(-) | |
| Short 100 shares | $60 | $100 | -$40 |
| Short 2 Dec 60 puts | $1.50 | $0 | +$3 |
| Overall loss per share | -$37 |
The total loss in this instance is:
$37 x 100 = $3700
If the price of RRR Corp trades at $20 on expiration:
| Beginning value | Ending value | Profit(+) or Loss(-) | |
| Short 100 shares | $60 | $20 | +$40 |
| Short 2 Dec 60 puts | $1.50 | $40 | -$77 |
| Overall loss per share | -$37 |
In this case, the total loss is:
$37 x 100 = $3700
As you can see, with large price swings in either direction, a huge loss will result.
Short Straddle, Short Call Straddle & Short Call Synthetic Straddle
The strategies above are comparable strategies in that they have a similar payoff profile.
Read : Short call synthetic straddle : Profit from little volatility