The short put synthetic straddle recreates the short straddle strategy by shorting the underlying stock and selling enough at-the-money puts to cover twice the number of shares sold. That is, for every 100 shares shorted, 2 put contracts must be written.
Sell 2 ATM Puts, Short 100 Underlying
Short put synthetic straddles are limited profit, unlimited risk options trading strategies that are used when the options trader feels that the underlying asset price will experience very little volatility in the near future.
Limited Profit Potential
Maximum profit for the short put synthetic straddle is achieved when the underlying stock price on expiration date is trading at the strike price of the options sold. At this price, both written put contracts expire worthless and the options trader gets to keep the entire net premium received taken as profit.
Net Premium Received - Commissions Paid
Profit achieved when: Price of Underlying = Strike Price of Short Put
Unlimited Risk
Large losses for the short put synthetic straddle can be sustained when the underlying stock price makes a strong move either upwards or downwards at expiration. A strong downward move will cause the uncovered short put to expire deep in-the-money while a strong upward move will cause the short stock position to suffer a severe loss.
Unlimited
Loss occurs when: Price of Underlying > Sale Price of Underlying + Net Premium Received OR Price of Underlying < Strike Price of Short Put - Net Premium Received
Loss = Price of Underlying - Sale Price of Underlying - Net Premium Received OR Strike Price of Short Put - Price of Underlying - Net Premium Received + Commissions Paid
Breakeven points
Sale Price of Underlying + Net Premium Received
Strike Price of Short Put - Net Premium Received
Example
Suppose XYZ stock is trading at $40 in June. An options trader implements a short put synthetic straddle by selling two JUL 40 puts for $200 each and shorting 100 shares of XYZ stock for $4000. The net premium received for writing the put contracts is $400.
If XYZ stock is trading at $30 on expiration in July, the two JUL 40 puts expire in-the-money and has an intrinsic value of $1000 each. Buying back the the put options to close out the position will cost the trader $2000. However, the short stock position posted a gain of $1000. Taking into account the net premium of $400 received, the short put synthetic straddle's loss comes to: $2000 - $1000 - $400 = $600.
On expiration in July, if XYZ stock is still trading at $40, both the JUL 40 put contracts expire worthless while the short stock position broke even. Hence, the short put synthetic straddle trader made his maximum profit which is equal to the initial $400 net premium received upon entering the trade.
Commissions
These examples exclude commissions and fees. Include all transaction costs when evaluating the profit or loss of a position.
Similar strategies
Short Call Synthetic Straddle
The synthetic short straddle can also be implemented using calls instead of puts and that strategy is known as the short call synthetic straddle.
Long Put Synthetic Straddle
Since the short straddle can be synthetically constructed, similarly, the long straddle can be recreated using the long put synthetic straddle strategy. Long put synthetic straddles are used when the underlying stock price is perceived to be highly volatile.