Synthetic Long Stock (Split Strikes) Explained

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Synthetic Long Stock (Split Strikes)

The synthetic long stock (split strikes) is a less aggressive version of the synthetic long stock.

The synthetic long stock (split strikes) position is created by buying slightly out-of-the-money calls and selling an equal number of slightly out-of-the-money puts of the same underlying stock and expiration date.

Synthetic Long Stock (Split Strikes) Construction
Buy 1 OTM Call
Sell 1 OTM Put

The split strike version of the synthetic long stock strategy offers some downside protection. If the trader’s outlook is wrong and the underlying stock price falls slightly, he will not suffer any loss. On the flip side, a stronger upside move is needed to produce a profit.

Profits and losses with a split strike strategy are also not as heavy as a corresponding long stock position as the strategist has traded some potential profits for downside protection.

Unlimited Profit Potential

Similar to a long stock position, there is no maximum profit for the synthetic long stock (split strikes). The options trader stands to profit as long as the underlying stock price goes up.

The formula for calculating profit is given below:

  • Maximum Profit = Unlimited
  • Profit Achieved When Price of Underlying > Strike Price of Long Call – Net Premium Received
  • Profit = Price of Underlying – Strike Price of Long Call + Net Premium Received

Unlimited Risk

Like the long stock position, heavy losses can occur for the synthetic long stock (split strikes) if the underlying stock price takes a dive.

Often, a credit is taken when establishing this position. Hence, even if the underlying stock price remains unchanged on expiration date, there will still be a profit equal to the initial credt taken.

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The formula for calculating loss is given below:

  • Maximum Loss = Unlimited
  • Loss Occurs When Price of Underlying

Breakeven Point(s)

The underlier price at which break-even is achieved for the synthetic long stock (split strikes) position can be calculated using the following formula.

  • Breakeven Point = Strike Price of Short Put – Net Premium Received OR Strike Price of Long Call + Net Premium Paid

Example

Suppose XYZ stock is trading at $40 in June. An options trader setups a split-strikes synthetic long stock by selling a JUL 35 put for $100 and buying a JUL 45 call for $50. The net credit taken to enter the trade is $50.

Scenario #1: XYZ stock price rise moderately to $45

If the price of XYZ stock rises to $45 on expiration date, both the long JUL 45 call and the short JUL 35 put will expire worthless and the trader keeps the initial credit of $50 as profit.

Scenario #2: XYZ stock rallies explosively to $60

If XYZ stock rallies and is trading at $60 on expiration in July, the short JUL 35 put will expire worthless but the long JUL 45 call expires in the money and has an intrinsic value of $1500. Including the initial credit of $50, the options trader’s profit comes to $1550. Comparatively, a corresponding long stock position would have achieved a larger profit of $2000.

Scenario #3: XYZ stock price crashes to $20

On expiration in July, if the price of XYZ stock has instead crashed to $20, the long JUL 45 call will expire worthless while the short JUL 35 put will expire in the money and be worth $1500. Buying back this short put will require $1500 and subtracting the initial $50 credit taken when entering the trade, the trader’s loss comes to $1450. A heavier loss of $2000 loss would have been suffered by a corresponding long stock position.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Synthetic Long Stock

There is a more aggressive version of this strategy where both the call and put options involved are at-the-money. While a smaller upside movement of the underlying stock price is required to accrue large profits, this alternative strategy provides less room for error.

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Synthetic Long Stock (Split Strikes) Explained

Having explained the synthetic long stock position and its near perfect correlation to an actual stock purchase, we turn today to a variation of the same – the synthetic long stock with “spilt strikes.”

What? Cloven hooves?

Not to worry, friends. It’s much easier than it sounds.

You’ll recall that the synthetic long stock strategy is comprised of two components – an at-the-money call purchase and an at-the-money put sale. You’ll recall also that this combination mirrors the profit/loss profile of a straight stock purchase almost exactly.

Our trade today simply widens the strikes on the trade somewhat, going out of the money on both the call and the put, and setting up a risk/reward profile that’s slightly more muted than the above-mentioned synthetic long stock position.

As always, an example best illustrates the strategy.

Below is a chart of energy giant Exxon Mobil (NYSE: XOM) spanning a period that encompasses both a steep drop and subsequent spike higher.

Let’s imagine that in the middle of August, after careful consideration, you come to the opinion that Exxon Mobil has hit its low and is about to bounce higher. With the stock trading at exactly $75 (red circle) you take action and initiate a synthetic long stock strategy with split strikes.

You opt for the split strike approach because you’re not entirely convinced the worst is over, and you want to afford yourself an additional cushion should the stock fall further before rebounding the way you expect. You’re also prepared to give up a little upside on the trade in order to create that cushion.

You take one final look at the chart and initiate your bet as follows:

You purchase one October 77 call for $2.00 and sell one October 73 put for $2.30. Your total credit on the trade is $0.30.

Key Trading Levels

The trade’s break-even point is the put strike less the premium earned on the trade, or $72.70 ($73 – $0.30). Anything above that level and you’re guaranteed to take home the gravy. (For the sake of comparison, had you bought the stock at $75 and seen a corresponding fall to $72.20, you’d have been out $280).

In this case, however, the trade worked in your favor, expiring at $83 (black circle), $6.00 in the money, for a net gain of $630 ([$6 + $0.30]) x 100). As a reminder, one options contract equals 100 shares of stock.

Not bad, but consider that had you just purchased the stock at $75, you would have earned $800 over the same period.

Muted Profit/Loss Profile

And what if things had gone sour? After all, the stock drifted lower after you initiated the trade, meandering in the $72 range for almost a month before moving higher (blue box). Had the options expired there, you would have been out $70 ([$73 – $72 – $0.30] x 100). By comparison, had you been long the stock, you’d be out $300.

The synthetic long stock with split strikes offers investors a safer way to play the traditional synthetic long stock strategy. Keep in mind, though, that a diminished profit potential is the price one pays for reduced risk.

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Long Combination

AKA Synthetic Long Stock; Combo

The Strategy

Buying the call gives you the right to buy the stock at strike price A. Selling the put obligates you to buy the stock at strike price A if the option is assigned.

This strategy is often referred to as “synthetic long stock” because the risk / reward profile is nearly identical to long stock. Furthermore, if you remain in this position until expiration, you will probably wind up buying the stock at strike A one way or the other. If the stock is above strike A at expiration, it would make sense to exercise the call and buy the stock. If the stock is below strike A at expiration, you’ll most likely be assigned on the put and be required to buy the stock.

Since you’ll have the same risk / reward profile as long stock at expiration, you might be wondering, “Why would I want to run a combination instead of buying the stock?” The answer is leverage. You can achieve the same end without the up-front cost to buy the stock.

At initiation of the strategy, you will have some additional margin requirements in your account because of the short put, and you can also expect to pay a net debit to establish your position. But those costs will be fairly small relative to the price of the stock.

Most people who run a combination don’t intend to remain in the position until expiration, so they won’t wind up buying the stock. They’re simply doing it for the leverage.

Options Guy’s Tips

It’s important to note that the stock price will rarely be precisely at strike price A when you establish this strategy. If the stock price is above strike A, the long call will usually cost more than the short put. So the strategy will be established for a net debit. If the stock price is below strike A, you will usually receive more for the short put than you pay for the long call. So the strategy will be established for a net credit. Remember: The net debit paid or net credit received to establish this strategy will be affected by where the stock price is relative to the strike price.

Dividends and carry costs can also play a large role in this strategy. For instance, if a company that has never paid a dividend before suddenly announces it’s going to start paying one, it will affect call and put prices almost immediately. That’s because the stock price will be expected to drop by the amount of the dividend after the ex-dividend date. As a result, put prices will increase and call prices will decrease independently of stock price movement in anticipation of the dividend. If the cost of puts exceeds the price of calls, then you will be able to establish this strategy for a net credit. The moral of this story is: Dividends will affect whether or not you will be able to establish this strategy for a net credit instead of a net debit. So keep an eye out for them if you’re considering this strategy.

The Setup

  • Buy a call, strike price A
  • Sell a put, strike price A
  • The stock should be at or very near strike A

Who Should Run It

NOTE: The short put in this strategy creates substantial risk. That is why it is only for the most advanced option traders.

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