Introduction To Synthetic Long stock With Options Of Different Strike Prices(split strikes)
A synthetic long stock strategy consists of a combination of options that results in a risk and reward profile that is similar to holding on to the underlying security. It can be created by writing an out of the money put and an out of the money call where both put and call have different exercise or strike prices. Hence, the term “split strikes”.
Steps
Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Assessment On Outlook – 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 unlimited profit
Step 9 : Profit calculation
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Setting up the trade
Step 12 : Exit Trade & Record Trade In Diary
Step 1 : Perform economic, fundamental and technical analysis
Assess the economy and perform fundamental analysis on the underlying security. Be certain that the price of the underlying security is headed upwards. The options trader should also look out for these chart patterns:
Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis
Step 2 : Assessment On Outlook – Bullish
The trader who executes a synthetic long stock strategy with different exercise or strike prices has a bullish outlook on the price of the underlying security. In general, if the price of the underlying security goes up, the trader stands a chance of making a profit. The converse is also true. When the price of the underlying security goes down, the trader stands a chance of making a loss.
However, due to the way the synthetic long stock with split strikes is constructed, there is a range of prices at which the profit stagnates. Hence, the gradient of the risk and reward graph of the synthetic long stock with split strikes is not a constant. In essence, there is a tradeoff between potential profits and losses in a synthetic long stock with split strike prices. Please refer to the payoff diagram.
Step 3 :Study the option chain
Study the options chain. Select the options to be used in the construction of a synthetic long stock position. Since this strategy involves “split strikes”, the options must be of different strike prices. Also, be mindful of the premium of the options. This will help a trader to calculate the breakeven points in step 4.
Read : Learn to read and understand options chain
Step 4 : Breakeven Analysis
The breakeven point is the price point at which there is zero profit and loss. The breakeven point can be calculated as:
Exercise or strike price of put – net credit
OR
Exercise or strike price of call + net credit
Step 5: Understand Your Profit Zones
After the breakeven point has been calculated, the trader should understand where the profit zone is. The profit zone is to the right of the breakeven point.
Step 6 : Unlimited loss potential
As with holding stocks, the loss potential is unlimited.
Step 7 : Loss calculation
The loss can be calculated as:
Exercise or strike price of put – price of underlying security – net credit + commissions paid to broker
Step 8 : Potential for unlimited profit
As with holding stock, there is a potential for an unlimited profit with a synthetic long stock with split strikes.
Step 9 : Profit calculation
The profit can be calculated as:
Price of the underlying security – strike price of call + net credit
Step 10 : Calculate Risk & Reward Ratio
Calculate the risk and reward ratio based on possible entry exit prices. Doing so will help a trader to determine the attractiveness of a trade on a risk and reward basis.
Read more : Understanding Risk/Reward Ratio For Option Traders
Step 11 : Setting up the trade
This strategy involves buying 1 out of the money call and 1 out of the money put. An equal number of puts and calls are bought..These calls and puts have different strike prices. The ratio of calls to puts is 1 : 1.
Step 12 : Exit Trade & Record Trade In Diary
Last but not least, the trader should exit the trade and record the trade’s performance in the diary for self reflection and analysis. The practice of doing so will help a trader to become better over time.
Example Of A Synthetic Long Stock With Different Strike Prices(Split Strikes)
The price of TTT Corp is trading at $50. A trader decides to do a synthetic long stock, using options of different strike prices. The trader :
- Buys 1 Dec 55 call @ $1.10
- Writes 1 Dec 45 put @ $1.50
As a result, a net credit is created when he enters the trade. The net credit is:
($1.50 – $1.10) x 100 = $40
Of course, it is not all the time that a net credit is received. Sometimes a net debit is created instead. For the purposes of simplicity, this example aligns with the formula given above.
If the price of TTT Corp trades at $50 on expiration of the options:
| Beginning value | Ending value | Profit(+) or Loss(-) | |
| Long 1 Dec 55 call | $1.10 | $0 | -$1.10 |
| Write 1 Dec 45 put | $1.50 | $0 | +$1.50 |
| Overall profit per share | +$0.40 |
The total profit is thus :
$0.40 x 100 = $40
Within a certain range of prices or when the price of the underlying security stagnates, the trades gains a profit of $40.
If the trader had bought stock at $50 instead, he would not have experienced any profit.
If the price of TTT trades at $10:
| Beginning value | Ending value | Profit(+) or Loss(-) | |
| Long 1 Dec 55 call | $1.10 | $0 | -$1.10 |
| Write 1 Dec 45 put | $1.50 | $35 | -$33.50 |
| Overall profit per share | -$34.60 |
The trader has has made a loss of:
$34.60 x 100 = $3460
If the trader has bought stock instead at $50, the trader would have made a loss of $4000. From this comparison, you should be able to tell that the losses at a $10 price point is greater with a long stock strategy than a synthetic long stock strategy with split strikes.
If the price of TTT trades at $80:
| Beginning value | Ending value | Profit(+) or Loss(-) | |
| Long 1 Dec 55 call | $1.10 | $25 | +$23.90 |
| Write 1 Dec 45 put | $1.50 | $0 | +$1.50 |
| Overall profit per share | +$25.40 |
His profit is thus:
$25.40 x 100 = $2540
If the trader had bought 100 shares stock instead at $50, his profit would have been $3000.
As you can see, the profit earned in a synthetic long stock with split strike prices is lower than that of just buying the stock outright.
Synthetic long stock with split strikes vs Synthetic long stock
A synthetic long stock with split strikes does not have a constant gradient. The synthetic long stock however has a constant gradient as it is constructed with options with the same strike price. This means that it is easier for the synthetic long stock to turn a profit than the synthetic long stock with split strikes. It also means that it is easier for the synthetic long stock to turn a loss than the synthetic long stock with split strike.
Long stock vs Synthetic long stock with split strikes
In general, at the same price points compared, a synthetic long stock will experience less profit and less loss. It is considered to be less aggressive than holding stock outright. It is also a less expensive strategy than buying stock outright.
Read: Synthetic Long Stock : Bullish strategy