Synthetic Short Call : Similar Payoff Profile To Short Call

Introduction To Synthetic Short Call

Synthetic short call

A synthetic short call is an artificially created trade that has a payoff diagram that is similar to a short call. The payoff of a synthetic short call is such that when the price of the underlying security declines slightly or stagnates, the trader will earn a maximum profit. Please refer to the payoff diagram shown in this article.

A Net Credit

Executing a synthetic short call will result in a net credit.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Slightly Bearish
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Unlimited loss
Step 7 : Loss calculation
Step 8 :  Limited profit potential
Step 9 : Calculate Risk & Reward Ratio
Step 10 : Set Up Trade – Execute a synthetic short call
Step 11 : Exit Trade & Record Trade In Diary

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Step 1 : Perform economic, fundamental and technical analysis

The options trader should look for tell tale signs in the economy and the fundamentals of the underlying that the markets are slightly bearish. Some of the chart patterns that option traders should look out for are:

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

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Step 2 : Outlook – Slightly Bearish

The trader who executes a synthetic short call is anticipating a stagnation or slight decline in the price of the underlying security such that the put option employed expire worthless. When that happens, the trader earns a maximum but limited profit.

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Step 3 :Study the option chain

Examine the options chain after assessing the outlook deciding on the outlook. Select the options to be used in the creation of a synthetic short call.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

The breakeven can be calculated as:

Short sale price of the underlying security – net credit

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Step 5: Understand Your Profit Zones

Synthetic short call

Once the breakeven has been calculated, understand that the profit zone is to the left of the breakeven.

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Step 6 : Unlimited loss

The loss is virtually unlimited since the price of the underlying security can go up infinitely. As long as the price if above the breakeven point, a loss is realisable.

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Step 7 : Loss calculation

The loss can be calculated as:

Price of underlying security – Breakeven point

The above formula does not take into account brokerage commissions. To do that, just add the brokerage commissions paid to the above result.

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Step 8 :  Limited profit potential

The maximum profit is equal to the net credit of the trade. But realistically, every trade is accompanies by brokerage commissions. Hence, the maximum profit can be calculated as:

Net credit – commissions paid to broker

The maximum profit can only be realised of the price of the underlying security is less than or equal to the exercise or strike price of the written puts.

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Step 9 : Calculate Risk & Reward Ratio

After the maximum profit is calculated, the trader should also calculate the risk involved when stop loss is in place. Next, the trader should calculate the risk and reward ratio. This will help a trader determine the attractiveness of the trader when compared to another trade of a similar nature.

Read more: Understanding Risk/Reward Ratio For Option Traders

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Step 10: Set Up Trade – Execute a synthetic short call

A trader can execute a synthetic short call by:

  • Writing 1 at the money put
  • Shorting 100 shares

The ratio is thus 1 written put for every 100 shares of the underlying security shorted.

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Step 11: Exit Trade & Record Trade In Diary

Last but not least, exit the trade and record the trade in a diary for analysis and review. This is one of the tools that can help a trader to become better.

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Read: Synthetic short stock position: Profit on price declines (Using A Single Strike Price)

Synthetic short stock: Using puts and calls with different strike prices ( Using Split Strikes)

Short call: Earn premium when option expires

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