Synthetic Short Stock Position : Profit From Price Declines (Using A Single Strike Price)

Introduction To Synthetic Short Stock Position( Using Single Strike Price)

Synthetic short stock

A synthetic short stock position is created with options which has a resultant payoff profile which is similar to that of short stock position. A synthetic short stock position is created by buying at the money puts and writing an equal number of call options. The options must be derived from the same underlying security and must have the same expiration date.

The synthetic short stock position is to to be differentiated from a synthetic short stock position with split strikes as the latter uses option which have different exercise or strike prices, modifying the strategy into a less aggressive one.

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 : Potential for unlimited loss
Step 7 : 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 short stock position
Step 12 : Exit Trade
Step 13 : Record Trade In Diary

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Step 1 : Perform economic, fundamental and technical analysis

Before arriving at step 2 as shown below, the options trader should perform economic, fundamental and technical analysis to ascertain the direction of the financial security in question. The options trader should look out for certain chart patterns such as:

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

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Step 2 : Outlook : Bearish

The trader who uses a synthetic short stock position is bearish on the price of the underlying security and is expecting a price decline. The greater the price decline, the greater than realisable profit.

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Step 3 :Study the option chain

Study the options chain and select the options to be used in the synthetic short stock position. Be mindful that this strategy involves using a single strike price.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

After the selection of the options to be used, the trader would be able to perform breakeven analysis.

The breakeven point can be calculated as:

Put exercise or strike price – net credit

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Step 5: Understand Your Profit Zones

Synthetic short stock

The preceding step to understanding the profit zones are being able to calculate the breakeven points. The graph here illustrates the profit zones.

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Step 6 : Potential for unlimited loss

As with shorting stocks, the losses are potentially unlimited because the price of the underlying security can go up infinitely. A loss occurs when the price of the underlying security is greater than the breakeven point.

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Step 7 : Loss calculation

The loss can be calculated as:

Price of the underlying security – breakeven point – commissions paid to broker

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Step 8 : Potential for unlimited profit

As with shorting stock, the profit potential is unlimited. A profit is realisable when the price of the underlying security is less than the breakeven point

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Step 9 : Profit calculation

Breakeven point – price of underlying security

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Step 10 : Calculate Risk & Reward Ratio

With stop losses in place and an estimated potential profit, the options trader should calculated the risk and reward ratio. Doing so will help the trader to determine the attractiveness of the trade on a risk and reward basis.

Read more : Understanding Risk/Reward Ratio For Option Traders

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Step 11 : Set Up Trade – Executing a synthetic short stock position

A trader who executes a synthetic short stock position will:

  • Write 1 at the money call
  • Buy 1 at the money put

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Step 12 : Exit Trade

Consider exiting the trade as the price of the underlying security moves above the breakeven point, especially if there is little possibility of the price reversing to the downside. Also consider, placing stop losses as there is a potential of a large loss. If there is a reasonable profit in the position, consider exiting the position fully as well.

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Step 13 : Record Trade In Diary

Next, record the trade’s performance in a diary for reflection and analysis. By doing so, the options trader will be able to improve his trading skills over time.

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Example Of A Synthetic Short Stock Position Using A Single Strike Price

PQR Corp is currently trading at a price of $60. A trader anticipates a price decline in the underlying security. As a result, he executes a synthetic short stock position by:

  • buying 1 Dec 60 put @ $1.10
  • selling 1 Dec 60 call @ $1.70

The result is a payoff profile that looks similar to that of a short stock position. Since the put has lower premium, there is a resultant net credit that is collected by the trader as he establishes the trade. This net credit can be calculated as:

($1.70 – $1.10) x 100 = $60

The breakeven point can be calculated as:

$60 – ($1.70 – $1.10) = $59.40

Let us examine 2 price points. One above the breakeven point and another below the breakeven point.

If the price of PQR is trading at $70 on expiration:

Beginning value Ending value Profit(+) or Loss(-)
Long 1 Dec 60 put $1.10 $0 -$1.10
Short 1 Dec 60 call $1.70 $10 -$8.30
Overall loss per share -$9.40

In this case the total loss is:

$9.40 x 100 = $940

In the case of shorting stock however, if the stock is covered at a price of $70:

Beginning value Ending value Profit(+) or Loss(-) on a per share basis
Short 100 shares of PQR at price of $60 $60 $70 -$10

The total loss when 100 shares of stock is shorted instead is :

$10 x 100 = $1000

Let us compare the total loss of the 2 strategies above at the price point of $70.

Strategy type Total loss
Short Short 100 shares of PQR at price of $60 $1000
Synthetic short stock position with 1 ATM put and 1 ATM call $940

As you can see, the loss in a synthetic short stock position is lesser than the total loss of actually shorting the stock. This is an advantage that a synthetic position has over the actual short stock position.

If the price of PQR is trading at $50 on expiration:

Beginning value Ending value Profit(+) or Loss(-)
Long 1 Dec 60 put $1.10 $10 +$8.90
Short 1 Dec 60 call $1.70 $0 +$1.70
Overall profit per share +$10.60

The total profit is thus:

$7.20 x 100 = $720

In the case of shorting stock however, if the stock is covered at a price of $50:

Beginning value Ending value Profit(+) or Loss(-) on a per share basis
Short 100 shares of PQR at price of $60 $60 $50 +$10

The total profit comes to:

$10 x 100 = $1000

Let us compare the total profit of the 2 strategies above at the price point of $50.

Strategy type Total profit
Short Short 100 shares of PQR at price of $60 $1000
Synthetic short stock position with 1 ATM put and 1 ATM call $1060

As you can see, the synthetic position has a slightly higher total profit at the same price point of $50.

Synthetic short stock position vs Short stock position

In general, there are several advantages that a synthetic short position confers to the trader. That is:

  1. Possibly lower losses at the same price point
  2. Possibly higher profits at the same price point
  3. There is no need for a trader to pay dividends on dividend paying securities
  4. Effortless execution without the need to borrow the underlying security to short it

Advice

If you are considering a less aggressive strategy to a synthetic short stock position, use the synthetic short stock position with split strikes, employing options which are out of the money instead as a buffer for losses. The trade off is this: lower profits sacrificed for a greater buffer for losses.

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

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