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.
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:
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:
The underlier price at which break-even is achieved for the synthetic short 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 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.
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.
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.
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.
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 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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