Execute A Synthetic Long Put – Bearish Strategy

Introduction To Synthetic Long Put

Execute A Synthetic Long Put

A synthetic long put is an artificially constructed put which consist of buying at the money calls and writing an equivalent number of shares against it. By doing so, a trader creates a risk and reward profile which is similar to that of a long put. In general, when the price of the underlying security decreases below the breakeven point, the realisable profit also increases.

A long put simply involves buying put options to capture price moves to the downside. In comparison, a long put is relatively simpler to execute than a synthetic long put.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook :  Bearish
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Limited loss
Step 7 : Maximum loss calculation
Step 8 : Potential for unlimited profit
Step 9 : Profit calculation
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade – Executing a synthetic long put
Step 12 : Exit Trade
Step 13 : Record Trade In Diary

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Step 1 : Perform economic, fundamental and technical analysis

First, it is important to perform economic analysis. Next, fundamental analysis should be performed to figure out if the underlying security is overvalued or undervalued. In a synthetic long put, one should look out for factors that will cause the price of the underlying security to plummet. For example, if a certain company is over indebted, it might have problems pay off its debt. This might cause creditors to file claims against the company. In the process, the company’s stock price will decrease significantly. One is only able to discover such facts by reading the annual reports and performing fundamental analysis. Last but not least perform technical analysis to find a suitable entry point into a security, and potentially, an exit point as well. The trader can look out for these chart patterns:

Read: Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis

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Step 2 :Outlook :  Bearish

The trader that executes a synthetic long put is doing so in anticipation of a price decline in the underlying security. When that happens, the trader stands a chance of earning a profit from the trade.

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Step 3: Study the option chain

Study the option chain and select the put options to be used in the construction of a synthetic long put.  Also take note of the current price of the  underlying security.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

The breakeven point can be calculated as:

Shorted price of the underlying security  – Option premium paid

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Step 5: Understand Your Profit Zones

Execute A Synthetic Long Put

After the breakeven point has been calculated, the trader is able to understand the profit zones. If the price of the underlying security is below the breakeven point, the trade is in profitable territory.

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Step 6: Limited loss

Since the synthetic long put has the same risk and reward profile of a long put ( Buying a put), the potential loss is a limited one. This limited loss is also known as the maximum loss that can be incurred on the trade.

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Step 7: Maximum loss calculation

The maximum loss can be calculated as :

Option premium paid + commissions paid to broker

If one were to ignore the commissions paid to the broker, the maximum loss would be thus equal to the option premium paid.

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Step 8 : Potential for unlimited profit

The profit potential of a synthetic long put is unlimited. What the trader is looking for is a significant decline in the price of the underlying security with a large magnitude. By way of contrast, a $20 decline in the price of the underlying security is better than a $2 as a $20 decline yields a greater profit. The greater the magnitude of the price decline, the greater the profit, conditional on the price of the underlying security trading below the breakeven point.

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Step 9 : Profit calculation

The synthetic long put is only profitable when the price of the underlying security trades below the breakeven point. The breakeven point can be expressed as:

Shorted price of the underlying security – option premium paid

Therefore, a profit is realisable when:

Price of the underlying security is < (Shorted price of the underlying security – option premium paid)

Building on what has been mentioned above, the profit can be calculated as:

Shorted price of the underlying security  – option premium paid – current trading price of underlying security

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Step 10 : Calculate Risk & Reward Ratio

After calculating potential profit and risk, one is able to calculate the risk and reward ratio. Do so to calculate the attractiveness of the trade.

Read: Understanding Risk/Reward Ratio For Option Traders

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Step 11 : Set Up Trade – Executing a synthetic long put

A trader who executes a synthetic long put will:

  • Long 1 at the money call
  • Short 100 shares

The ratio above has to be adhered to because each option contract is representative of 100 shares of the underlying security.

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Step 12 : Exit Trade

If the trade is reasonably profitable, the options trader can exit the trade. If the call option has expired and if the trader is still of the view that the underlying security is headed downwards, the trader could hold onto the short position for a profit. If the call option has expired and there is a loss of the underlying security, the trader should consider exiting the trade especially  if his view has changed. If the price of the underlying security has gone up(call option still has not expired) and there is little chance of the underlying security moving downwards, then the trade should be offsetted totally.

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Step 13 : Record Trade In Diary

Record the trade in a journal or diary. Discover your weaknesses, strengths and biases as a trader and find ways to improve on the trade process. Reflect and improve.

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Example Of A Synthetic Long Put

The price of GGG Corp is trading at $50. A trader performs economic, fundamental and technical analysis and predicts that the price of the underlying security is headed towards the range of $10 to $20. The reason is because interest rates are moving upwards and there is little chance that the debt can be paid down within the next 3 years. Also, the sales revenue of the company is set to decrease over the next 12 months as predicted by analysts. The trader decides to execute a synthetic long put by buying a Dec 50 call at a cost of $250 and shorting 100 shares of GGG Corp at a price of $50.Eventually, the price of the underlying security reaches the $15 level and the trader exits the trade entirely. The realised profit was :

$5000 – $1500 – $250 = $3250

Read : Execute A Long put: Profit from price movements to the downside

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