Synthetic Short Put : Profit From Bullish Or Stagnating Conditions

Introduction To Synthetic Short Put

Synthetic short put

The synthetic short put, as its name suggests, is an artificially constructed trade which has a payoff that is similar to that of a short put. The synthetic short put however, is not made up of puts. It is created by buying the shares and writing  at the money calls against it. This is popularly known as the covered call. Hence, the covered call is also a synthetic short put.

Steps

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

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Step 1 : Perform economic, fundamental and technical analysis

The first step is to perform economic, fundamental and technical analysis. This is done to ascertain that the price of the underlying security and the markets in general are rising or at the very least trading sideways. Here are some suggested chart patterns to look out for:

The trader’s job is to execute the trade before the breakout to the upside.

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

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Step 2 : Outlook – Slightly Bullish

In a short put strategy, the trader will earn a maximum profit when the price of the underlying security increases or stagnates. When that happens, the put option will expire worthless. Similarly in a synthetic short put strategy, the trader will also earn a maximum profit when the price of the underlying security increases or stagnates.

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Step 3 :Study the option chain

Examine the options chain. Select the options to be used in the creation of the synthetic short put.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

The breakeven point is the price point at which an intersection on the horizontal axis of the payoff diagram occurs. The breakeven point can be calculated as:

Acquisition price of the underlying security – net credit

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Step 5: Understand Your Profit Zones

Synthetic short put

Once the breakeven point has been calculated, the trader should know that the profit zone is to the right of the breakeven point.

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Step 6 : Unlimited loss potential

In general, the greater the price decline below the breakeven point, the greater the loss. The condition for loss is this. As long as the price of the underlying security is less than the breakeven point, a loss is realisable.

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Step 7 : Loss calculation

The loss for a synthetic short put is :

Acquisition price of the underlying security – trading price of underlying security – net credit + commissions paid to the broker

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Step 8 : Potential for limited profit

The profit potential of a synthetic short put is a limited one. A maximum profit is realisable when the price of the underlying security is greater than or equal to the exercise or strike price of the call involved.

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Step 9 : Profit calculation

The maximum and limited profit can be calculated using the formula below.

Net credit – commissions paid to the broker

The net credit is the premium received from writing the calls against the ownership of the underlying security.

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Step 10 : Calculate Risk & Reward Ratio

With stop losses in place, the options trader should  calculate the risk and reward ratio as it will give him a sense of the attractiveness of the trade.

Read more : Understanding Risk/Reward Ratio For Option Traders

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

A trader who executes a synthetic short put is essentially executing a covered call. He can do so in the following ratio:

  • Buy 100 shares of the underlying security
  • Write 1 call option based on the underlying security

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Step 12 : Exit Trade & Record Trade In Diary

Last but not least, after the trade has been exited, the trade’s performance should be recorded in  a diary for reflection and analysis.

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Example Of A Synthetic Short Put

WWW is a company that is trading at $50 per share. A trader writes a call option at a strike price of $50 and collects a premium of $250 from it. He also buys 100 shares of the underlying. By the expiration date of the options, the WWW was trading at a price of $60. The gain on the underlying security is :

($60 – $50) x 100 = $1000

However, the loss on the call option was :

$10 x 100 – $250 = $750

Hence, the resultant and maximum profit was:

$1000 – $750 = $250

If the trader modifies the strike price of the option to an OTM call option, the profit could potentially be higher, assuming all things remain constant.

Short put : Profit from stagnant and rising markets

Learn how a professional options trader/hedge fund manager writes naked options to increase returns

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