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Twitter 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.
A 95% Success Rate
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