Synthetic Straddles Made Simple
There’s a
saying on Wall Street about no free lunches, but if you’re
an options trader, you might be able to walk away with a “gift,”
courtesy of Wall Street. The gift
that I’m talking about is a position trade that Kevin Haggerty calls a
synthetic straddle in some of his morning columns. From my days
on the options floors of the AMEX and the PSE, I’ve always referred to
it as a “gamma position.” In its essence, the synthetic
straddle is nothing more than a “regular” straddle. As a
trader with a basic understanding of options, you know that this type
of position is quite simply a bet on future price movement, or
volatility. For those unfamiliar with general option strategies I
would suggest looking over Tony
Saliba’s Option Workbook. We will give a brief definition of the
risk and reward characteristics of the straddle in the following text,
but this article is geared for those of you already familiar with the
mechanics of how puts and calls work, and would like to better
understand the conceptual framework that’s involved in a slightly more
involved, but potentially lucrative trade.
An options straddle is comprised of an
equal number of purchased call and put contracts with the same
expiration date and strike price. The object of “buying premium,”
as this is sometimes referred, is a trader’s way of “making a
bet” on future volatility in the product of their choice. There
are different types of volatility, but to keep it simple while
learning the broad strokes of a new strategy, we will be referring to
the underlying stock’s volatility when we make further use of this
term. When contracts are bought, it can be thought of as a race
against time. Ultimately, options either expire worthless, or in the
money. As buyers of premium, such as with a straddle position, our
initial bet when making the purchase is for one side of our position,
either the call or the put, to go dramatically in the money. At
expiration, barring a “pin” at the strike which we
established our trade, we will end up with one contract that is
worthless, while the other one has some intrinsic value. Intrinsic
value is how much a contract is worth at the close of every option
traders favorite day, that third Friday of the month. With intrinsic
value being a function of how far the closing stock price is away from
our strike that we purchased,…well, it doesn’t take a rocket
scientist to know that we’re hoping for a “moon shot” of
price in either direction in the underlying stock.
A simple example of a regular straddle
position would involve purchasing the XYZ 50 level straddle for 2
points with two weeks until expiration, and the stock at 50. It
doesn’t matter in this case how much we paid for the individual
components (the calls or puts). We are only concerned with the total
outlay of capital, in this case 2 points, or 200 bucks a contract. If
no action had been taken by our buyer of premium until expiration
Friday, and the stock so happened to close at 55, we would then have a
very happy straddle buyer. His initial 2 point outlay would now be
worth 5 points. The calls would be $5 “in the money,” the
puts worthless, and his pockets lined with an extra 3 points, after
accounting for the original admission price of 2 dollars. Not a bad
ride, but there’s more creative ways to play a straddle, that can
ultimately lead to even better results while reducing the initial risk
in the process. Are you ready?
With a synthetic straddle we have the
opportunity to scalp stock that is built in to our original position.
Instead of using an equal number of call and put contracts that
simultaneously hedge the initial directional bet ( assuming “at
the money” options ), we use a combination of stock and options.
The “Synthetic Straddle” also requires this key ingredient
of volatility, and without its participation it must be stated, that
both the regular and synthetic strategies will test your patience, as
well as your trading account. Unlike its cousin, the synthetic is used
mostly by market professionals. One of the reasons for this might be
that synthetics require holding stock overnight, rather than just
options, and as such, the margin required can be considerably more of
a financial burden if one isn’t adequately capitalized. For every
negative there is a positive, and with our synthetic, one of the
privileges is the flexibility to scalp the underlying stock against
our option contracts. Huh?? In establishing the synthetic the trader
has one of two choices (the ratios below reflect a synthetic straddle
looking for movement or volatility, but with no initial directional
bias when using At -The- Money options and stock):
1. Buy “X” amount of Put
contracts, and hedge the initial directional price risk with a Long
stock equivalent equal to 1/2 of the number of contracts purchased.
For instance in our XYZ example, with the stock at 50, we could buy
500 shares of the underlying XYZ, and simultaneously buy 10 of the 50
level Puts.
2. Buy “X” amount of Call
contracts, and hedge this directional risk into a synthetic straddle
by simultaneously “shorting” 1/2 as much stock. In this
case, using the same numbers as above, we short 500 XYZ as we purchase
10 of the 50 Level Calls.
In a perfect world the choice between
the two is something for academics to discuss. In the real world with
traders having to deal with margin requirements, uptick rules, and
potential “hard to borrow” stock issues, I’d say most
traders have a tendency to use long stock versus puts when trading
equity issues. However, if you’re trading index proxies such as the
semiconductors
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then most all of the above listed concerns go the way of the dinosaur
and you’re free to flip a coin.
The ratio in both of these choices
effectively neutralizes directional risk (initially), because our 10
contracts, when “at the money”, have approximately a 50%
chance of finishing “in the money,” or “out of the
money,” by expiration. At expiration, if the contract is “in
the money,” then the put or call acts just like stock, and would
be assigned a 100% figure, or “delta” (the rate at which the
contract moves with the underlying on a point by point basis). If the
contract finishes “out of the money,” it would be assigned a
zero delta. So for everyday that exists between “the now,”
and expiration, the contract would have a delta percentage falling
somewhere between 0 and 100%. This is why this ratio works when the
traders intentions are to capture “a move,” but doesn’t want
the initial directional risk, but only the “premium or volatility
risk.”
It is the stock component and initial
ratio that gives a trader the ability to potentially trade the
position’s stock for scalping profits, during the interim, prior to
the option’s expiration. Don’t worry if you’re still confused by how
this all works, as our example trade is a very good position for
showing how uncomplicated, and easy this can all be. For now, the one
other point that I would like to bring up before we go into our trade
is your “net stock position”.
The ability to scalp stock is dictated
by the “net stock position.” With equity options one
contract is the equivalent of 100 shares of the underlying. For
instance, with our XYZ example, if we bought 10 of the puts this would
be the equivalent of being short 1000 shares of stock. If the initial
synthetic consisted of 10 puts and long 500 shares of XYZ as our
hedge, in effect we will still be short 500 shares…that is if the
underlying stock decreases in price below the strike, before
expiration. At expiration, in this case we would exercise our puts, 10
contracts remember, thus establishing a short position of 1000 shares.
But remember, we had already purchased 500 shares, so our net position
is short 500 XYZ. For our position, this translates into a “very
good thing.” The further below our strike price the better,
because we now get to buy stock at a much lower price than where we
effectively shorted it (strike price minus the initial premium). This
stock purchase will average our cost of long stock (stock bought now
plus the initial purchase at time synthetic was put on). On the other
hand, if the stock did a “moon shot” to the upside we would
be long 500 shares for the ride, minus our now worthless premium
outlay. For simplicity’s sake let’s say our stock XYZ gapped up 10
points on a takeover bid. In this case we would stand to profit by
$5000 (500 * 10pts.) minus the premium paid for our straddle. We would
also now have to sell 500 shares of stock, at much higher prices, to
rid ourselves of any further directional risk, in what became a very
profitable synthetic straddle trade. Pheeww!!
O.K., so now we’re ready to get into
the real meat and potatoes of the synthetic. Remember how, in our very
classic example XYZ, that the investor waited until expiration to take
action on his call and put position? Well, with our friend the
synthetic, we turn off the snooze button and try to take advantage of
the volatility that takes place over the life of our position. Instead
of waiting around for two weeks to expire, and hoping that an
exceptional move has taken place, and then “do the stock,”
we take off our golf spikes, put on the trading jacket, and scalp
stock against the position before expiration!!! By successfully
scalping stock against our position, we whittle down the potential
“decay,” or premium risk that we have, since we did
initially purchase contracts.
Below, we’ll be going through a
synthetic straddle in the Dow Jones ETF, the
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through the trade you’ll see our thought process, how the position
evolved, and ultimately decide for yourself just how aggressive you
want to be with the synthetic straddle. Are you a buyer yet? Maybe
after finishing up you will be, as you might decide to add your own
rules that fit your own personal style of trading.
As stated already, straddles, and their
synthetic cousins, are bottom line, all about making a calculated bet
on the future volatility of the instrument of our choice. Just like
when one trades stock, a well designed trading plan includes
contingencies for entering and exiting based on technicals and proper
risk management. We’re not here to tell you how you have to trade, but
in the following example you will see one way in which the synthetic
straddle could be traded very profitably over the course of a three
week period. What you do after that is all up to you, as the clock is
still ticking towards yet another expiration!!!
In our trade example we are going to
dynamically “scalp” our synthetic straddle using a
combination of technical analysis on both the VIX (cboe volatility
index), and the DIAs.
In the above chart we have a daily
price graph of the CBOE Volatility index, or “VIX”
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as it is most often referred. As with equities, and indices, the
ability to use technical analysis is one way of gauging probable short
term future movement on this index. On March 3rd, with three weeks
left until the next options expiration, the VIX was showing a
potentially oversold condition from which it could bounce. Price
action had dropped down to the recent lows of the VIX’s trading range
(shown by green horizontal lines), which at the time was also testing
a 20-Period, 2 Standard Deviation Bollinger Band. The VIX, which
measures “crowd sentiment” of fear and complacency, was
demonstrating some complacency on this day. When the index is
establishing relative lows, like on March 3rd, it essentially
underscores the point that investors are not “buying
protection” for their equity positions. The VIX’s overwhelming
tendency is to move contra to equity indices, or proxies, such as the
DIAs, SPYs, and the QQQs. Since “the crowd” is usually wrong
at extremes, the VIX, which was now potentially “oversold,”
was indicating a high probability trade opportunity. When a trader
wants to execute a trade based on “market volatility” the
purest way to do this is through the use of equity index options, like
the ETFs. We can’t buy the VIX per se, but as I mentioned, it is
directly correlated to the price action in the market indices.
In our trade we looked to take
advantage of the VIX price action by using the Dow Jones Industrials
ETF, the DIA. For this trade it was decided that the Synthetic
Straddle was the best way to position ourselves for a “pick
up” in volatility. Although we will normally associate low VIX
readings with a potential sell off in equity indices, we decided that
a volatility bet, without having to chose a price direction, was best
suited for a more conservative trade. To execute this position we
would therefore put on the Synthetic Straddle, “delta
neutral”, using At-The-Money options.
In the above 60-Minute chart of the DIA,
one could have established the Synthetic Straddle by purchasing the
At-The-Money 80 level Calls for 1.75 versus approximately 79.60 stock
on March 3rd, during the first 30 minutes of trade (due to a technical
issue this could not be labeled, but can be seen as part of the first
price bar on our trade date). We used the Calls in this example as the
uptick rule that effects equities is not a problem for trading ETFs
such as the Diamonds. Therefore, to establish the delta neutral
synthetic we need to buy calls and sell stock at a 2:1 ratio (remember
our 50% premise). In the vein of simplicity, let’s say 10 of the 80
level (strike) Calls were used versus 500 shares sold of the DIA. Now
we need “something,” namely underlying volatility in the
Diamonds to “pick up” for our trade to begin to work
effectively.
As fate, or the market gods would have
it, we put on our volatility play at a very good time. Looking at the
VIX chart once more, we can see that the volatility levels did indeed
reverse, trending higher from our original entry point on March 3rd.
By March 12th you could honestly “smell the fear” that was
once more prevalent in the market place. I personally was hearing
things like, ‘ we’re going to 60 in the VIX!!’, and ‘equities are
definitely going to break the October lows.’ Scary, eh? You bet, and
that’s why it was the perfect time to “shore up” our
volatility position.
On March 12th, with the VIX ‘now going
to 60′, we looked to see what was really happening. Price levels in
the VIX had gone up over 30% since March 3rd, but just as important,
we were showing excellent technical signs that a potential reversal
was imminent. March 12th’s action pierced the recent trading range
resistance levels, as well as a longer term trend line extending from
the July to October peaks. This also happened to be the first price
action that was penetrating our Bollinger Bands. As a trader who
“bought on the cheap”, you knew that it was time to once
again execute.
Referring back to our price chart of
the DIAs, you can see what had happened to our underlying stock
position during the explosion in volatility. The DIAs had retreated
into a solid downtrend, and giving us an opportunity to hedge our
original Synthetic Straddle. With prices down to nearly 74, our 80
Calls were “essentially worthless.” Even with the explosion
in volatility (which has the effect of pumping up option prices),
because the index had moved considerably away from our point of entry,
and time had elapsed (only 7 trading days left until expiration), we
were the “not so proud” owners of what appeared to be
worthless Calls…or were we?
With the Calls trading as
“worthless” or “rip ups” (something I’ve always
called them when they’re offered for .15 or less), we could assign our
Calls a delta that was fast approaching zero. This is a key point, and
how the dynamic hedging of our straddle works most effectively (btw
there are plenty of software vendors that can keep real time “greeks”
for option positions). As our premium outlay was lost in this case
(from 1.75 to under .15) and the market lost ground, our position had
actually gained ground very effectively. Remember, we still had a
position of short 500 DIAs from 79.60. As Kevin Haggerty likes to say,
“It’s too easy!!!” We now needed to take action!
Although we only show the 60-Minute
price chart here (which does show a nice doji like reversal bar off
the bands), using the a la Haggerty 1,2,3 reversal strategy on the
5-Minute chart, we had an excellent trigger to “buy in” our
short 500 shares somewhere between 74.65 – 74.85. Using the midpoint,
the stock scalp was worth 4.85. Translated into net profit results,
since our “bet” cost us 1.75 to start on a 2:1 ratio, we now
had a “worthless Call” for the remaining 7 days, established
for a credit of approximately .70. Now, regardless of what the market
had in store for us, we stood to profit by at least .70 or $700…and
oh boy, look at what happened next!!!
Can you say “Moon shot” to
the upside? “Oh baby”, is right. This deserves another,
“It’s too easy.” In our trade, by keeping to the VIX as our
guide for exiting, and also for the practicality of keeping it simple,
the trade would have worked itself out into a “monster trade.”
As the DIAs reversed, and subsequently rallied from “the
abyss” of panic, our position which was comprised of being long
“worthless” Calls (for a credit), turned into something
worth a whole lot more. By expiration day, with the DIAs closing at
85.13, and the VIX finally reversing back down to the “lower
band” of support, our 80 Strike Calls were now deep In-The-Money,
and worth over 5 points. Add in the credit of .70 on the 10 Calls, and
you’ve got a trade worth $5700. Remember to send a thank you note to
Mr. Market, but congratulate yourself, by now being able to go out and
get another “gift.” Thank you Wall Street!!