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