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The synthetic short stock with split strikes strategy is a means of muting both the risk and reward of a straight short sale, while at the same time avoiding the often complicated issues that arise when shorting.
In this article, we’re going to examine the synthetic short with split strikes with an eye to distinguishing it from its sister strategy, the straight synthetic short stock.
We’ll begin with this: The essential difference between the two resides in how close one chooses to replicate the risk/reward profile of an actual short sale.
Let’s turn to a real life example to better illustrate the point.
How Do We Build It?
First, let’s recall that a synthetic short stock strategy is composed of a long at-the-money put and a short at-the-money call, both with the same expiry. Remember, too, that such a pairing effectively mimics the risk/reward profile of a short sale to a tee.
The synthetic short with split strikes simply widens the strikes between the two so that both options are slightly out of the money. The resulting profit/loss profile means you’ll make less if you’re right on the trade – but also lose less if you’re wrong.
Here’s a chart of Smith & Wesson Holding Corp. (NASDAQ: SWHC) for the last six months:
Let’s imagine it’s late May, and you believe Smith & Wesson is about to get smacked. All your research points to an imminent decline in the shares, but you’re not a gambler by nature and you’d prefer, if possible, to hedge your bets – just in case you’re wrong, or your timing is off.
With the stock sitting at exactly $15.50 (red circle), you select a synthetic short stock with split strikes strategy using the following options:
- You purchase one SWHC September $14.50 put for $2.00; and
- Sell one SWHC September $16.50 call for $1.75.
- Your total credit for the trade is $0.25.
In the ensuing weeks the stock trades another 10% higher before it begins its descent.
And what a descent! Smith & Wesson falls almost 50% peak to trough and your options expire with the shares at exactly $10.00.
Your profit on the trade is $475 ([$14.50 – $10.00 + $0.25] x 100). Remember, one options contract is equivalent to 100 shares of stock.
Had you gone short the stock from the outset, your profit would have been larger: $550 ($1,550 – $1,000).
What About Losses?
On the flip side, had you received a margin call on your short sale while the stock was rising in June – or had you otherwise been forced to close your short at, say, $17.00 – your loss would have been $150 ($1,700 – $1,550).
With the split strike strategy, however, if your options expired at the same $17.00, the long put would have expired worthless, the $16.50 call would be in the money $0.50 and your loss would have been $25 ([$17.00 – $16.50 + $0.25] x 100).
Split strikes: Less pain. Less gain.
You won’t find this anywhere else
You’ll never read about this powerful trading strategy in the Wall Street Journal. Or see it discussed on CNBC. Ninety-nine out of 100 brokers know nothing about it. Yet this nearly risk-free trading system has been able to turn $330 into $3,300. And it’s been put together by one man who wants to share its secrets with you. Discover them right here.