Synthetic Straddle: Unlock the Power of Volatility Trading

A synthetic straddle is a known options trading strategy. It involves buying both a call option and a put option on the same underlying asset. The strike prices of the call and put options are identical. The goal is to profit from volatility in the price of the underlying asset.

How a synthetic straddle works

A synthetic straddle aims to simulate a regular straddle. A regular straddle involves buying both a call and a put option on the same asset at the same strike price.

You buy a synthetic straddle when you think an asset's price will experience a significant move higher or lower. You do not know which way the price will move. You only expect increased volatility.

With a synthetic straddle, you do not actually buy call and put options. Instead, you create the equivalent positions. Typically, you use stock and options together to create the synthetic straddle.

There are two main ways to create a synthetic straddle:

1. Long stock + long put
Buy 100 shares of the underlying stock. Also buy 1 put option on the stock. The put strike price equals the current stock price. This combination mimics a long call option. The stock provides unlimited upside. The put option limits the downside to the strike price.

2. Short stock + long call
Short 100 shares of the underlying stock. Also buy 1 call option on the stock. The call strike price equals the current stock price. This combination mimics a long put option. The call option provides unlimited upside. The short stock position limits the downside to the strike price.

When to use a synthetic straddle

• You expect an increase in volatility for a stock, but not the overall market. Using a regular straddle on a single stock requires large capital. The synthetic version has lower cash requirements.
  
• Implied volatility is relatively low. When implied volatility is low, options tend to be cheap. This helps limit the cost of the synthetic straddle.
  
• You want to profit from volatility alone. A synthetic straddle has almost no directional bias. You do not need to predict if the stock will rise or fall. As long as it makes a big move in either direction, the position profits.
  
• You want to avoid limitations on regular options. With a synthetic straddle, you can achieve effective leverage beyond what you could access with standard options alone.
  

How to construct a synthetic straddle?

Want to set up a synthetic straddle? Here’s how you can:

1. Identify the stock you think will experience a volatility spike. Look for a stock that isn’t too volatile right now but has the potential for a big price move soon.
   
2. Determine appropriate strike prices. Check the available option strike prices and select one that’s close to the stock’s current price. This helps keep the position balanced.
   
3. Buy 100 shares of stock or short 100 shares. If buying stock, match the share amount to the options contract size. If shorting, borrow the shares through your broker.
   
4. Buy 1 put and 1 call at chosen strike. Buy both a put and a call on the stock at the strike price you selected.
   
5. Manage the position as volatility expands. As implied volatility rises, the value of the options will increase. You can sell the options to lock in profits.
   

Follow the specific synthetic straddle method that aligns with your outlook. If bullish, buy stock and buy put. If bearish, short stock and buy call. Either creates similar payoff as a regular straddle.

Risks and drawbacks of synthetic straddles

Synthetic straddles come with inherent risks and disadvantages.

• Requires advanced options knowledge. Synthetic positions involve nuanced options strategies beyond basic calls and puts. Ensure you fully understand the options leg before attempting synthetic straddles.
• Potential for unlimited losses. Short stock positions bring the risk of unlimited loss if the stock rallies. Define and stick to a risk management plan to limit potential downside.
• Complex adjustments and management. Rebalancing a synthetic straddle requires multiple transactions across stock and options legs. Compare to simpler adjustments for regular straddles.
• Higher commissions and fees. The multiple-leg structure leads to increased trading costs. Account for higher commissions when estimating your breakeven points.
• Subject to early options exercise. The short options leg brings the risk of early exercise. Plan for potential early assignment and how you will manage.

Example of a synthetic straddle

Let's say you want to position for volatility expansion in ABC stock. ABC currently trades at Rs. 3,000 per share. You expect a sharp move soon but are unsure of direction. You decide to use a synthetic straddle.

You short 100 shares of ABC stock at Rs. 3,000 to establish the bearish leg. You also buy 1 put option contract with a strike price of Rs. 3,000 for a premium of Rs. 100 per share.

This combination provides the same payoff as a long call option. The short stock position limits your maximum loss to Rs. 3,000. The long put lets you profit if ABC falls below Rs. 3,000.

You also go long 100 shares of ABC stock at Rs. 3,000 for the bullish side. And you buy 1 call option contract with a Rs. 3,000 strike at the same Rs. 100 premium.

Now you have synthetic long call and put options at Rs. 3,000. You benefit from a volatility spike in either direction. If ABC rises above Rs. 3,300 or falls below Rs. 2,700, you book a profit.

Conclusion

A synthetic straddle offers a way to benefit from volatility without the large capital for a regular straddle. Combining stock and options lets you mimic straddle exposure. Pay attention to risks like unlimited loss potential and early exercise. But in the right context, synthetic straddles provide effective leveraged access to volatility spikes. Monitor for low-volatility stocks poised for a big move and consider using a synthetic straddle.