Synthetic Short Stock (Split Strikes)

[Igor 10]

A trader who implements a synthetic short stock (split strikes) is betting that an asset's value will fall. The technique involves buying the same number of call and put options for an underlying asset with the same expiration. Both the profit potential and the risk involved when using this strategy is unlimited. An investor who enters a synthetic short stock (split strikes) strategy can gain large profits if the market crashes but can also incur big losses if it rallies.

 

Moneyness Review for Puts and Calls

 

Call Options:

In-The-Money (ITM) = Strike Price (less than) Market Price

Out-of-The Money (OTM) = Strike Price (more than) Market Price

 

Put Options:

In-The-Money (ITM) = Strike Price (more than) Market Price

Out-of-The Money (OTM) = Strike Price (less than) Market Price

 

Both Put and Call Options

At-The-Money (ATM) Strike Price = (equals) Market Price

 

How to Implement a Synthetic Short Stock (Split Strikes) Strategy

 

 

Disney stock is worth $40 (market price) in June.

1) Trader sells a call option: DISJul45($1)

- 100 shares of DIS stock

- Strike Price $45, out-of-the-money (OTM), expiring in 30 days

- Premium Cost of $1.00

2) Trader buys a put option: DISJul35($0.50)

- 100 shares of DIS stock

- Strike Price $35, out-of-the-money (OTM), expiring in 30 days

- Premium Cost of $1.00

3) The trader receives a $50 credit when entering the market. [$100 (received from sale) - $50 (paid for put)]

Total cost to enter the market: -$50

 

Result one: Disney stock falls (moderately) to $35 in July.

a) The call sold option expires worthless. (OTM)

b) The put option purchased expires worthless. (OTM)

c) The trader gains a total of $50 after keeping credit taken when entering the market.

 

Result two: Disney stock rises (rallies) to $60 in July.

a) The put option expires worthless. (OTM)

b) The call option sold expires ITM. The investor who bought the trader's call option exercises his or her right to buy 100 shares at $45.

c) The trader buys 100 Disney shares in the open market, paying $6000.

d) He or she then sells them to the buyer, receiving $4500.

e) The trader loses a total of $1450 after subtracting the premium credit taken when entering the market. [$1450 = $50 (credit to enter market) - $1500 (loss from call)]

 

Result three: Disney stock falls (crashes) to $20

a) The call option expires worthless. (OTM)

b) The put option expires ITM, so the trader buys 100 Disney shares in the open market, paying $2000 to cover the sale.

c) The trader exercises his or her right to sell the 100 shares at $35 to the writer and receives $3500 from the seller.

d) The trader gains a total of $1550 after adding the premium credit taken when entering the market. [$1550 = $1500 (profit from put) + $50 (credit to enter market)]

 

Advantages and Disadvantages of Implementing a Synthetic Short Stock (Split Strikes):

 

Pluses: The upside to this type of strategy is that the investor will always make a profit in a bear market, which can lead to unlimited profit potential if prices crash. The trader also can enter the market without paying cash. He or she receives a premium credit, keeping it when the index call option expires worthless, and using the credit to offset losses, if the asset's value rises.

 

Minuses: The downside in using a synthetic short stock (split strikes) is that the method exposes the investor to unlimited risk. If the underlying asset's market value rallies, then he or she can lose large amounts of money, since an asset's price can theoretically rise as much as the demand permits.