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 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, who 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 trader’s 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 “moonshot” 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 are more creative ways to play a straddle that can ultimately lead to even better results, while reducing 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):
- 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.
- 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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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 every day 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 “moonshot” 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!!
OK, 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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PowerRating). In reading 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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PowerRating) 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 3, 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 vs. 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 12 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 12, 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 3, but just as important, we were showing excellent technical signs that a potential reversal was imminent. March 12’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 “moonshot” 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!!