Options Trading Made Easy: Synthetic Short Call Straddle

A short straddle strategy is implemented with the sale of two options: an at-the-money call and an at-the-money put. And it’s traded with one goal in mind: to profit from an upcoming lack of volatility in the underlying security.
If there is, indeed, little volatility, and the options expire precisely at the strike price of those two short options, the trader keeps the full premium received at the outset of the trade. That’s the best-case scenario.

Why Go ‘Synthetic’?

A synthetic short straddle replicates exactly the profit/loss profile of a short straddle and can be set using either calls or puts. Below we expand on the implementation and uses of the synthetic short call straddle.
Let’s look first at how it’s made.
A synthetic short call straddle has two components:

• The purchase of 100 shares of the underlying security; and
• The sale of two at-the-money calls.

This 2-to-1 relationship between calls and 100 shares of the underlying must be maintained in order for the risk/reward profile of a short straddle to remain operative (e.g., long 200 shares, short four at-the-money calls).

Taking It to the Street

Let’s examine a real-life trading scenario in order to better understand how and when a synthetic short call straddle might be employed.
Below is a chart of grocery retailer Kroger Co. (NYSE: KR). Let’s say you’ve owned the stock for years. It has been moving nicely of late, but after a recent pullback, you expect the stock to go dormant for a while and drift sideways for a few months.

But instead of just sitting on the stock and waiting to collect the next dividend, you decide in mid-May to be proactive and initiate a synthetic short call straddle to take in some premium.
With the stock trading at roughly $11, you sell two at-the-money August 11 calls, each for $1.50, for a total credit of $300 (red circle).
Your break-even points on the trade, therefore, are $14 on the upside and $8 below.

A Tight Range

And, indeed, the stock snakes sideways for the next three months, moving no higher than $11.60 and no lower than $10.50.
You’re feeling good, and by the time August expiration rolls around, you’re vindicated. Kroger closes at $11.08. You close out both calls with an $8 loss on each and your total profit is $292 ($16 loss on the options  + $8 gain on the shares + $300 initial credit).
How does that compare with a straightforward short straddle?
Consider the numbers. By selling an at-the-money put and call for $1.50 each at the outset of the trade (a straightforward short straddle), your credit would have been $300.  At expiry, the put would have been worthless, while the call would have produced an $8 loss.  Buying it back would have left you with the selfsame $292 gain ($300 – $8).
NOTE: A short straddle is a limited gain, theoretically unlimited loss strategy.

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