Synthetic Long Stock (Split Strikes)

[Igor 10]

Traders who carry out a synthetic long (split strikes) stock strategy are betting that the market price for an option's underlying asset will go up. The technique involves buying call options and writing (selling) the same amount of put options for the identical underlying asset. Traders who use this method enter the market receiving a credit or paying nothing. The synthetic long (split strikes) is a less aggressive strategy than its cousin, the synthetic long stock, giving the trader more of a cushion against minor market downturns. The potential profit and the potential loss are unlimited when entering this type of synthetic position.

 

The Differences Between ITM, ATM and OTM for Puts and Calls

There are five ways to define the relationship between an option's strike price and the market price of its underlying asset for puts and calls. Understanding the differences between the terms is important when considering the risks involved in implementing a synthetic long (split strikes) stock strategy.

 

Put Options:

ITM - In The Money: The underlying asset's market price is less than option's strike price.

OTM - Out of The Money: The underlying asset's market price is more than option's strike price.

 

Call Options

ITM - In The Money: The underlying asset's market price is more than option's strike price.

OTM - Out of The Money: The underlying asset's market price is less than option's strike price.

 

Both Put and Call Options

ATM - At The Money: The underlying asset's market price equals the option's strike price.

 

How to Implement a Synthetic Long Stock Strategy (Split Strikes) (OTM)

 

 

XYZ is worth $40 (market price)

1) Trader writes (sells) a put option: XYZJun35($1)

- 100 shares of XYZ stock

- Strike Price $35 (OTM), expiring in 30 days

- Premium Cost of $1

2) Trader buys a call option: XYZJun45($.50)

- 100 shares of XYZ stock

- Strike Price $45 (OTM), expiring in 30 days

- Premium Cost of $.50

3) Trader receives a total credit of $50 in premiums to enter the market [$100 (received from put) - $50 (paid for call)].

 

Result one: XYZ hits $45 (Moderate Bull Market)

a) The put option expires worthless (OTM).

b) The call option expires worthless (ATM).

c) The trader makes a total profit of $50 after keeping the premium credit from the call and the put.

 

Result two: XYZ hits $60 (Explosive Bull Market)

a) The put option expires worthless (OTM).

b) The call option is ITM. The trader exercises his or her right to buy 100 shares at $45, pays $4500 to the seller and sells the 100 shares in the open market for $6000.

c) The trader makes a total profit of $1550 after adding the premium credit received when entering the market. [$1550 = $1500 (profit from call) + $50 (credit to enter market)]

 

Result three: XYZ hits $20 (Market Crashes)

a) The call option expires worthless (OTM).

b) The put option is ITM. The put buyer exercises his or her right to sell 100 shares at $35. The trader pays $3500 to the put buyer and sells the 100 shares received from the buyer in the open market for $2000.

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

 

Advantage and Disadvantage of Implementing a Synthetic Long Stock Strategy (Split Strikes):

 

Pluses: The upside to this type of strategy is that the investor can make unlimited profits in a bull market, since the potential growth of any underlying asset is infinite. Another advantage to this technique is that the investor can enter the market receiving a credit that she or she can use to offset minor market downswings.

 

Minuses: The downside in using synthetic long (split strikes) strategy is when the underlying asset's market value falls dramatically. When this happens, the trader's loss risk becomes unlimited, as an asset's market price can decline to a zero value.