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Several valuable observations on synthetic straddles have been posted this
week by Gitanshu and Ira. Here are a few remarks that might help to see
these strategies from yet another angle.
On Nov. 1, after having traded between 147 and 182 during the past few days,
PMCS could be expected to go lower. With the stock at about 160, a trader
might have bought a number of Nov. 150 Puts. Next day, PMCS fell about 10
points, giving an unrealized profit of more than 4 points in the options.
Suppose the trader wanted to stay in the trade, but also have upside
protection. Two ways to do this with straddles: one, go long the same number
of calls, e.g. Nov. 150 calls, thus creating a real straddle. OR, two, buy
half the equivalent number of PMCS shares, creating a synthetic straddle.
Which is preferable?
For a trader who wants to get in an out of one side of the position several
times, the answer is two - because of the ease with which one can buy and
sell stock, as compared to options. Ira rightly mentioned friction and
liquidity questions.
However, for a trader intending to hold this position for perhaps two weeks,
a different consideration comes into play. How much capital is bound by this
position? How much capital is left to establish positions in other stocks at
the same time? Well, it turns out that these synthetic straddles require
more than double the capital outlay. For options closer to expiration, the
factor is even higher.
Yes, you are saying, but what about that great enemy of long straddles -
time decay? After all, with only one leg of the position consisting of long
options, the synthetic straddle is only half as vulnerable to time decay.
Not true. Time decay is exactly the same for both.
To demonstrate, let us look at a stock currently priced at 77. A synthetic
straddle, long 10 Dec. 80 calls, short 500 shares, might be established.
What would be an equivalent straddle consisting only of options? The 10 Dec.
75 calls, 10 Dec. 75 puts straddle? No. A quick calculation shows that FIVE
each, not ten, of these calls and puts would make for an equivalent
position.
Thus, in both cases we are long the same number of options (10); therefore
we are going to observe the same time decay.
And the capital outlay mentioned above remains the critical criterion.
Well, these are just a few points. There would be more to say, but it's past
midnight here in Germany, so all I'll say for now is good night.
Kind regards,
Michael Suesserott
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