Synthetic Short Stock (Split Strikes) Explained

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Contents

Synthetic Short Stock (Split Strikes)

The synthetic short stock (split strikes) is a less aggressive version of the synthetic short stock strategy.

The synthetic short stock (split strikes) position is created by selling slightly out-of-the-money calls and buying an equal number of slightly out-of-the-money puts of the same underlying stock and expiration date.

Synthetic Short Stock (Split Strikes) Construction
Sell 1 OTM Call
Buy 1 OTM Put

The split strike version of the synthetic short stock strategy offers some upside protection. If the trader’s outlook is wrong and the underlying stock price rises slightly, he will not suffer any loss. On the flip side, a stronger downward move is necessary to produce a profit.

Profits and losses with a split strike strategy are also not as heavy as a corresponding short stock position as the strategist has traded some potential profits for upside protection.

Unlimited Profit Potential

Similar to a short stock position, there is no limit to the maximum possible profit for the synthetic short stock (split strikes). The options trader stands to profit as long as the underlying stock price goes down.

The formula for calculating profit is given below:

  • Maximum Profit = Unlimited
  • Profit Achieved When Price of Underlying

Unlimited Risk

Like the short stock position, heavy losses can occur for the synthetic short stock (split strikes) if the underlying stock price makes a sharp move upwards.

Often, a credit is usually taken when establishing this position. Hence, even if the underlying stock price remains unchanged on expiration date, there will still be a profit equal to the initial credt taken.

The formula for calculating loss is given below:

  • Maximum Loss = Unlimited
  • Loss Occurs When Price of Underlying > Strike Price of Short Call + Net Premium Received OR Price of Underlying > Strike Price of Long Put – Net Premium Paid
  • Loss = Price of Underlying – Strike Price of Short Call +/- Net Premium Paid/Received + Commissions Paid

Breakeven Point(s)

The underlier price at which break-even is achieved for the synthetic short stock (split strikes) position can be calculated using the following formula.

  • Breakeven Point = Strike Price of Short Call + Net Premium Received OR Strike Price of Long Put – Net Premium Paid

Example

Suppose XYZ stock is trading at $40 in June. An options trader setups a split-strikes synthetic short stock by buying a JUL 35 put for $50 and selling a JUL 45 call for $100. The net credit taken to enter the trade is $50.

Scenario #1: XYZ stock price falls slightly to $35

If the price of XYZ stock drops to $35 on expiration date, both the long JUL 35 put and the short JUL 45 call will expire worthless and the trader keeps the initial credit of $50 as profit.

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Scenario #2: XYZ stock rallies explosive to $60

If XYZ stock rallies and is trading at $60 on expiration in July, the long JUL 35 put will expire worthless but the short JUL 45 call expires in the money and has an intrinsic value of $1500. Buying back this short call will require $1500 and subtracting the initial $50 credit taken when entering the trade, the trader’s loss comes to $1450. A heavier loss of $2000 loss would have been suffered by a corresponding short stock position.

Scenario #3: XYZ stock price falls to $20

On expiration in July, if the price of XYZ stock has instead crashed to $20, the short JUL 45 call will expire worthless while the long JUL 35 put will expire in the money and be worth $1500. Including the initial credit of $50, the options trader’s profit comes to $1550. Comparatively, a corresponding short stock position would have achieved a greater profit of $2000.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Synthetic Short Stock

There is a more aggressive version of this strategy where both the call and put options involved are at-the-money. While a smaller downside movement of the underlying stock price is required to accrue large profits, this alternative strategy provides less room for error.

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Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Synthetic Short Stock (Split Strikes)

Definition:
A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).

For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the obligation.

For stock options, each contract covers 100 shares.

Buying Put Options

Put buying is the simplest way to trade put options. When the options trader is bearish on particular security, he can purchase put options to profit from a slide in asset price. The price of the asset must move significantly below the strike price of the put options before the option expiration date for this strategy to be profitable.

A Simplified Example

Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a month’s time is being priced at $2. You strongly believe that XYZ stock will drop sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ put option covering 100 shares.

Say you were spot on and the price of XYZ stock plunges to $30 after the company reported weak earnings and lowered its earnings guidance for the next quarter. With this crash in the underlying stock price, your put buying strategy will result in a profit of $800.

Let’s take a look at how we obtain this figure.

If you were to exercise your put option after earnings, you invoke your right to sell 100 shares of XYZ stock at $40 each. Although you don’t own any share of XYZ company at this time, you can easily go to the open market to buy 100 shares at only $30 a share and sell them immediately for $40 per share. This gives you a profit of $10 per share. Since each put option contract covers 100 shares, the total amount you will receive from the exercise is $1000. As you had paid $200 to purchase this put option, your net profit for the entire trade is $800.

This strategy of trading put option is known as the long put strategy. See our long put strategy article for a more detailed explanation as well as formulae for calculating maximum profit, maximum loss and breakeven points.

Protective Puts

Investors also buy put options when they wish to protect an existing long stock position. Put options employed in this manner are also known as protective puts. Entire portfolio of stocks can also be protected using index puts.

Selling Put Options

Instead of purchasing put options, one can also sell (write) them for a profit. Put option writers, also known as sellers, sell put options with the hope that they expire worthless so that they can pocket the premiums. Selling puts, or put writing, involves more risk but can be profitable if done properly.

Covered Puts

The written put option is covered if the put option writer is also short the obligated quantity of the underlying security. The covered put writing strategy is employed when the investor is bearish on the underlying.

Naked Puts

The short put is naked if the put option writer did not short the obligated quantity of the underlying security when the put option is sold. The naked put writing strategy is used when the investor is bullish on the underlying.

For the patient investor who is bullish on a particular company for the long haul, writing naked puts can also be a great strategy to acquire stocks at a discount.

Put Spreads

A put spread is an options strategy in which equal number of put option contracts are bought and sold simultaneously on the same underlying security but with different strike prices and/or expiration dates. Put spreads limit the option trader’s maximum loss at the expense of capping his potential profit at the same time.

You May Also Like

Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Synthetic Long Stock (Split Strikes)

The synthetic long stock (split strikes) is a less aggressive version of the synthetic long stock.

The synthetic long stock (split strikes) position is created by buying slightly out-of-the-money calls and selling an equal number of slightly out-of-the-money puts of the same underlying stock and expiration date.

Synthetic Long Stock (Split Strikes) Construction
Buy 1 OTM Call
Sell 1 OTM Put

The split strike version of the synthetic long stock strategy offers some downside protection. If the trader’s outlook is wrong and the underlying stock price falls slightly, he will not suffer any loss. On the flip side, a stronger upside move is needed to produce a profit.

Profits and losses with a split strike strategy are also not as heavy as a corresponding long stock position as the strategist has traded some potential profits for downside protection.

Unlimited Profit Potential

Similar to a long stock position, there is no maximum profit for the synthetic long stock (split strikes). The options trader stands to profit as long as the underlying stock price goes up.

The formula for calculating profit is given below:

  • Maximum Profit = Unlimited
  • Profit Achieved When Price of Underlying > Strike Price of Long Call – Net Premium Received
  • Profit = Price of Underlying – Strike Price of Long Call + Net Premium Received

Unlimited Risk

Like the long stock position, heavy losses can occur for the synthetic long stock (split strikes) if the underlying stock price takes a dive.

Often, a credit is taken when establishing this position. Hence, even if the underlying stock price remains unchanged on expiration date, there will still be a profit equal to the initial credt taken.

The formula for calculating loss is given below:

  • Maximum Loss = Unlimited
  • Loss Occurs When Price of Underlying

Breakeven Point(s)

The underlier price at which break-even is achieved for the synthetic long stock (split strikes) position can be calculated using the following formula.

  • Breakeven Point = Strike Price of Short Put – Net Premium Received OR Strike Price of Long Call + Net Premium Paid

Example

Suppose XYZ stock is trading at $40 in June. An options trader setups a split-strikes synthetic long stock by selling a JUL 35 put for $100 and buying a JUL 45 call for $50. The net credit taken to enter the trade is $50.

Scenario #1: XYZ stock price rise moderately to $45

If the price of XYZ stock rises to $45 on expiration date, both the long JUL 45 call and the short JUL 35 put will expire worthless and the trader keeps the initial credit of $50 as profit.

Scenario #2: XYZ stock rallies explosively to $60

If XYZ stock rallies and is trading at $60 on expiration in July, the short JUL 35 put will expire worthless but the long JUL 45 call expires in the money and has an intrinsic value of $1500. Including the initial credit of $50, the options trader’s profit comes to $1550. Comparatively, a corresponding long stock position would have achieved a larger profit of $2000.

Scenario #3: XYZ stock price crashes to $20

On expiration in July, if the price of XYZ stock has instead crashed to $20, the long JUL 45 call will expire worthless while the short JUL 35 put will expire in the money and be worth $1500. Buying back this short put will require $1500 and subtracting the initial $50 credit taken when entering the trade, the trader’s loss comes to $1450. A heavier loss of $2000 loss would have been suffered by a corresponding long stock position.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Synthetic Long Stock

There is a more aggressive version of this strategy where both the call and put options involved are at-the-money. While a smaller upside movement of the underlying stock price is required to accrue large profits, this alternative strategy provides less room for error.

You May Also Like

Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Best Binary Options Brokers 2020:
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    BINARIUM

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    Perfect for Beginners!
    Free Trading Education! Free Demo Acc!
    Get Your Sign-up Bonus Now:

  • BINOMO
    BINOMO

    Trustful broker.

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