Synthetic Short Stock : Use Puts & Calls With Different Strike Prices ( Using Split Strikes)

Introduction To Synthetic Short Stock

Synthetic short stock

When stock is shorted and the prices decrease, the trader exits the positions and earns a profit. A synthetic short stock with split strike is a combination of a long out of the money put and a short out of the money call which has an eventual payoff that is nearly similar to that of a shorted stock strategy. The options involved in the construction of a synthetic short stock are derived from the same underlying security, have the same expiration date but have different strike prices. The different strike prices utilised gives rise to the terms “split strikes”.

Synthetic short stock with split strikes vs synthetic short stock

The synthetic short stock is executed with at the money options and is a more aggressive strategy with greater potential profits and losses than the synthetic short stock with split strikes.

A net credit or debit

Depending on whether the put or the call is more expensive, a net credit or a net debit can be result. If the option premium for the long call is greater than that of the put, a net debit will result. If the option premium for the long call is less than that of the put, a net credit will result.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 :Assessment Of 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 with split strikes
Step 12 : Exit Trade
Step 13 : Record Trade In Diary
[top]

Step 1 : Perform economic, fundamental and technical analysis

To arrive at a conclusion that the markets and the underlying security in concern is likely  to have a bearish outlook, the trader must first perform economic, fundamental and technical analysis. An options trader would look for instances where the economy, the fundamentals of the underlying security and the technical outlook are all aligned in the same direction – Downwards. An example of this would be an expected rate hike and perhaps a poor earnings outlook for the underlying security. Some chart patterns that the options trader should look out for are:

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

[top]

Step 2 :Assessment Of Outlook – Bearish

In general, as the price of the underlying security goes below the breakeven point, a profit is realisable. The trader anticipates a move towards to the downside. When that happens,the probability of earning a profit increases.

[top]

Step 3: Study the option chain

In this step, the options trader is supposed to look and study the options chain to select the options to be used in the creation of the synthetic short stock.

Read: Learn to read and understand options chain

[top]

Step 4 : Breakeven Analysis

Next, breakeven analysis can be performed to find out where the breakeven points are.

The breakeven point can be calculated as:

Call strike price + net credit

OR

Put strike price – net debit

[top]

Step 5: Understand Your Profit Zones

Synthetic short stock

After calculating the breakeven point, know that the profit zone for a synthetic short stock strategy is to the right of the breakeven point.

[top]

Step 6 : Potential for unlimited loss

As with shorting stocks, there is a potential for unlimited losses as the price of the underlying security decreases. In order for a loss to occur, the price of the underlying security must be greater than the breakeven point.

[top]

Step 7 : Loss calculation

The loss can be calculated as :

Price of the underlying security – call strike price + net debit + commissions paid to broker

OR

Underlying security’s price – call strike price – net credit + commissions paid to broker

[top]

Step 8 : Potential for unlimited profit

There is a potential for unlimited profit when a trader executes a synthetic short stock with split strikes. A loss occurs when the price of the underlying security is greater than the breakeven point.

[top]

Step 9 : Profit calculation

The profit can be calculated in 2 ways depending on whether there is a resultant net debit or net credit.

Strike price of put – price of underlying security + net credit

OR

Strike price of put – price of underlying security – net debit

[top]

Step 10 : Calculate Risk & Reward Ratio

It would be a necessary step to calculate the risk and reward ratio and find out for every dollar of risk taken, what is the potential reward. At the end of the day, the reward should be worth the  risk taken as compared to trades of a similar nature. If one were to use a long put strategy instead with the intention to capture profits when the price of the underlying security moves downwards, is the risk and reward ratio better instead?

Read more: Understanding Risk/Reward Ratio For Option Traders

[top]

Step 11: Set Up Trade – Executing a synthetic short stock with split strikes

A trader can create a synthetic short stock with split strike by:

  • Long 1 out of the money put
  • Short 1 out of the money call

The long put to short call ratio is thus 1 to 1. Adherence to the ratio shown here makes the trade a synthetic short stock with split strikes.

[top]

Step 12 : Exit Trade

Put stop losses in place to minimise losses. Also if the profits in the position is reasonable, consider closing the position. The exit of  a position can be based on technical analysis or changed circumstances due to the economic outlook or the fundamental outlook.

[top]

Step 13 : Record Trade In Diary

The trader should also detail the trade’s performance in a diary for reflection and analysis. Doing do consistently over time will help the trader to sharpen his trading skills.

[top]

Example Of A Synthetic Short Stock Using Split Strikes

Suppose XYZ Corp is currently trading at a price of $60. A trader wants to create a synthetic short stock trade with split strikes, meaning that he will use options with different strike prices. The trader creates the synthetic short stock position by:

  • writing a Dec 65 call @ $1.40
  • buying a Dec 55 put @ $1

As a result, a net credit is created. This net credit is equal to:

($1.40 – $1) x 100 = $40

Let’s examine 3 price scenarios, $40, $60 and $80.

When the price of XYZ Corp is trading at $40 on expiration of the options:

Beginning value Ending value Profit(+) or Loss(-)
Write Dec 65 call $1.40 $0 -$1.40
Long Dec 55 put $1 $15 +$14
Overall profit per share +$12.60

The total profit is thus:

$12.60 x 100 = $1260

If the trader shorts 100 shares at $60 and covers at $40, a profit of $2000 is realised.

Strategy Profit when underlying price @ $40
Shorted stock $2000
Synthetic short stock with split strikes $1260

As you can see, the profit realised in a synthetic short stock position with split strikes is less than the profit realised when the stock is shorted and covered at $40. The synthetic position is thus a less aggressive position with smaller profits at the same price decrease.

When the price of XYZ Corp is trading at $60 on expiration of the options:

Beginning value Ending value Profit(+) or Loss(-)
Write Dec 65 call $1.40 $0 +$1.40
Long Dec 55 put $1 $0 -$1
Overall profit per share +$0.40

The total profit realisable at $60 is:

$0.40 x 100 = $40

Strategy Profit when underlying price @ $60
Shorted stock $0
Synthetic short stock with split strikes $40

Within a certain range, the the maximum profit of a synthetic short stock with split strikes is $40 which is equal to the net credit received.

When the price of XYZ Corp is trading at $80 on expiration of the options:

Beginning value Ending value Profit(+) or Loss(-)
Write Dec 65 call $1.40 $15 -$13.60
Long Dec 55 put $1 $0 -$1
Overall profit per share -$14.60

The total profit using a synthetic short stock with split strikes is:

$14.60 x 100 = $1460

Strategy Loss when underlying price @ $80
Shorted stock (100 shares) $2000
Synthetic short stock with split strikes $1460

The synthetic position’s loss is a lot less than that of the shorted stock. This is why the synthetic short stock with split strikes is also known as a less aggressive strategy than shorting stock outright – smaller potential losses and smaller potential profits.

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

[top]