Synthetic Short Call Explained

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    The Best Binary Options Broker 2020!
    Good for Beginners!
    Free Education + Free Demo Account!
    Get Your Sign-Up Bonus Now!

  • Binomo
    Binomo

    Only For Experienced Traders!

Synthetic Short Stock

The synthetic short stock is an options strategy used to simulate the payoff of a short stock position. It is entered by selling at-the-money calls and buying an equal number of at-the-money puts of the same underlying stock and expiration date.

Synthetic Short Stock Construction
Buy 1 ATM Put
Sell 1 ATM Call

This is an unlimited profit, unlimited risk options trading strategy that is taken when the options trader is bearish on the underlying security but seeks an alternative to short selling the stock.

Unlimited Profit Potential

Similar to a short stock position, there is no maximum profit for the synthetic short stock. The options trader stands to profit as long as the underlying stock price goes down.

Additionally, a credit is usually taken when entering this position since calls are generally more expensive than puts. Hence, even if the underlying stock price remains unchanged on expiration date, there will still be a profit equal to the initial credit taken.

The formula for calculating profit is given below:

  • Maximum Profit = Unlimited
  • Profit Achieved When Price of Underlying

Unlimited Risk

Like the short stock position, heavy losses can occur for the synthetic short stock if the underlying stock price shoots upwards.

The formula for calculating loss is given below:

  • Maximum Loss = Unlimited
  • Loss Occurs When Price of Underlying > Strike Price of Short Call + Net Premium Received
  • Loss = Price of Underlying – Strike Price of Short Call – Net Premium Received + Commissions Paid

Breakeven Point(s)

The underlier price at which break-even is achieved for the synthetic short stock position can be calculated using the following formula.

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    The Best Binary Options Broker 2020!
    Good for Beginners!
    Free Education + Free Demo Account!
    Get Your Sign-Up Bonus Now!

  • Binomo
    Binomo

    Only For Experienced Traders!

  • Breakeven Point = Strike Price of Long Put + Net Premium Received

Example

Suppose XYZ stock is trading at $40 in June. An options trader setups a synthetic short stock by buying a JUL 40 put for $100 and selling a JUL 40 call for $150. The net credit taken to enter the trade is $50.

If XYZ stock rallies and is trading at $50 on expiration in July, the long JUL 40 put will expire worthless but the short JUL 40 call expires in the money and has an intrinsic value of $1000. Buying back this short call will require $1000 and subtracting the initial $50 credit taken when entering the trade, the trader’s loss comes to $950. Comparatively, this is very close to the loss of $1000 for a short stock position.

On expiration in July, if XYZ stock is instead trading at $30, the short JUL 40 call will expire worthless while the long JUL 40 put will expire in the money and be worth $1000. Including the initial $50 credit taken, the trader’s profit comes to $1050. This amount closely approximates the $1000 gain of the corresponding short 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).

Advantages vs Short Stock

Three important reasons make the synthetic short stock strategy superior to actual short selling of the underlying stock. Firstly, there is no need to borrow stock to short sell. Secondly, there is no need to wait for the uptick, thus transactions are more timely. Finally, there is no need to pay dividends on the short stock (if the underlying security is a dividend paying stock).

Synthetic Short Stock (Split Strikes)

There is a more aggressive version of this strategy where both the call and put options involved are out-of-the-money. While a larger downside movement of the underlying stock price is required to make large profits, this split strikes strategy does provide more room for error.

Synthetic Long Stock

The converse strategy to the synthetic short stock is the synthetic long stock, which is used when the options trader is bullish on the underlying but seeks an alternative to purchasing the stock itself.

You May Also Like

Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Synthetic Short Call

A synthetic short call is created when short stock position is combined with a short put of the same series.

Synthetic Short Call Construction
Short 100 Shares
Sell 1 ATM Put

The synthetic short call is so named because the established position has the same profit potential a short call.

Limited Profit Potential

The formula for calculating maximum profit is given below:

  • Max Profit = Premium Received – Commissions Paid
  • Max Profit Achieved When Price of Underlying

Unlimited Risk

The formula for calculating loss is given below:

  • Maximum Loss = Unlimited
  • Loss Occurs When Price of Underlying > Sale Price of Underlying + Premium Received
  • Loss = Price of Underlying – Sale Price of Underlyingl – Premium Received + Commissions Paid

Breakeven Point(s)

The underlier price at which break-even is achieved for the synthetic short call position can be calculated using the following formula.

  • Breakeven Point = Sale Price of Underlying + Premium Received

You May Also Like

Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Short Call

What Is a Short Call?

A short call option position in which the writer does not own an equivalent position in the underlying security represented by their option contracts. Making a short call is an options trading strategy in which the trader is betting that the price of the asset on which they are placing the option is going to drop.

How Does a Short Call Work?

A short call strategy is one of two simple ways options traders can take bearish positions. It involves selling call options, or calls. Calls give the holder of the option the right to buy an underlying security at a specified price.

If the price of the underlying security falls, a short call strategy profits. If the price rises, there’s unlimited exposure during the length of time the option is viable, which is known as a naked short call. To limit losses, some traders will exercise a short call while owning the underlying security, which is known as a covered call.

Real World Example of a Short Call

Say Liquid Trading Co. decides to sell calls on shares of Humbucker Holdings to Paper Trading Co. The stock is trading near $100 a share and is in a strong uptrend. However, the Liquid group believes Humbucker is overvalued, and based on a combination of fundamental and technical reasons, they believe it eventually will fall to $50 a share. Liquid agrees to sell 100 calls at $110 a share. This gives Paper the right to purchase Humbucker shares at that specific price.

Selling the call option allows Liquid to collect a premium upfront; that is, Paper pays liquid $11,000 (100 x $110). If the stock heads lower over time, as the Liquid gang thinks it will, Liquid profits on the difference between what they received and the price of the stock. Say Humbucker stock does drop to $50. Then Liquid reaps a profit of $6,000 ($11,000 – $5,000).

Things can go awry, however, if Humbucker shares continue to climb, creating limitless risk for Liquid. For example, say the shares continue their uptrend and go to $200 within a few months. If Liquid executes a naked call, Paper can execute the option and purchase stock worth $20,000 for $11,000, resulting in a $9,000 trading loss for Liquid.

If the stock were to rise to $350 before the option expires, Paper could purchase stock worth $35,000 for the same $11,000, resulting in a $24,000 loss for Liquid.

Short Calls Versus Long Puts

As previously mentioned, a short call strategy is one of two common bearish trading strategies. The other is buying put options or puts. Put options give the holder the right to sell a security at a certain price within a specific time frame. Going long on puts, as traders say, is also a bet that prices will fall, but the strategy works differently.

Say Liquid Trading Co. still believes Humbucker stock is headed for a fall, but it opts to buy 100 $110 Humbucker puts instead. To do so, the Liquid group must put up the $11,000 ($110 x 100) in cash for the option. Liquid now has the right to force Paper, who is on the other side of the deal, to buy the stock at this price – even if Humbucker shares drop to Liquid’s projected $50 a share. If they do, Liquid has made a tidy profit – $6,000.

In a way, it’s achieving the same goal, just through the opposite route. Of course, the long put does require that Liquid shell out funds upfront. The advantage is that unlike the short call, the most Liquid can lose is $11,000, or the total price of the option.

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    The Best Binary Options Broker 2020!
    Good for Beginners!
    Free Education + Free Demo Account!
    Get Your Sign-Up Bonus Now!

  • Binomo
    Binomo

    Only For Experienced Traders!

Like this post? Please share to your friends:
Binary Options Trading
Leave a Reply

;-) :| :x :twisted: :smile: :shock: :sad: :roll: :razz: :oops: :o :mrgreen: :lol: :idea: :grin: :evil: :cry: :cool: :arrow: :???: :?: :!: