Disadvantages■
The rate of leverage is much slower than simply buying a call.
■
This can be considered expensive because you have to buy the stock and theput.
7.2.6 Exiting the TradeExiting the Position■
If the share falls below the strike price, you will make a limited loss.
■
If the share rises above the strike price plus the put premium you paid, youwill make a profit.
■
For any exit, you can either sell the stock or sell the put, or both. If the sharerises and you believe that it may fall afterwards, then you can just sell the stockand wait for the put to regain some of its value before selling that, too.
Mitigating a Loss■
You have already mitigated your losses by buying the puts to insure your longstock position.
7.2.7 ExampleABCD is trading at $35.50 on June 1, 2004.Buy 1,000 shares of stock at $35.50.Buy 10 August 2004 35 strike puts at $2.55.Net Debit
Stock bought  premium bought$35.50  $2.55  $38.05$38,050
Maximum Risk
Stock price  put premium  put strike$35.50  $2.55  $35.00  $3.05$3,050
Maximum Reward
Uncapped
Breakeven
Put strike  put premium  stock price  put strike$35.00  $2.55  $35.50  $35.00  $38.05
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Notice how low the maximum risk is: just $3,050 compared to the net debit of$38,050. That’s the effect of the insurance you’ve bought for only 2.55 (or $2,550).Now let’s see what would happen if we tried a lower strike put.Buy 1,000 shares of stock at $35.50.Buy 10 August 2004 30 strike puts at $0.80.Net Debit
Stock bought  premium bought$35.50  $0.80  $36.30$36,300
Maximum Risk
Stock price  put premium  put strike$35.50  $0.80  $30.00  $6.30$6,300
Maximum Reward
Uncapped
Breakeven
Put strike  put premium  stock price  put strike$30.00  $0.80  $35.50  $30.00  $36.30
The lower put strike is cheaper, but it gives us less insurance on the downside. Ourbreakeven is also friendlier with the lower put strike trade, so you should buy asmuch insurance as you think you’ll need. The more insurance you require, the moreexpensive it will be, but the less risk you’ll be taking.
7.3 Synthetic PutProficiency
Direction
Volatility
Asset Legs
N/ANovice
Bearish
Max Risk
Max Reward
Strategy Type
Uncapped
Capital Gain
!
■ Short Stock
Capped
■ Long Call
7.3.1 DescriptionEffectively an insurance policy for covering a short position, the Synthetic Put is theopposite of a Synthetic Call. Basically, we short the stock and buy an ATM or slightly OTM (higher strike) call. The net effect is that of creating the same shape as a standard Long Put but with the same leverage as shorting the stock, and we create a netcredit instead of a net debit.In simple terms, this means that we’re capping our downside in case the stockunexpectedly rises through our stop loss. The Long Call will increase in value if thestock rises, thereby countering the loss in value of the short stock position.
Sell stock
Steps to Trading a Synthetic Put1. Short the stock.2. Buy ATM (or OTM) calls.
Buy call
Synthetic Put
Synthetic Strategies■
Notice that you have created the risk profile of a put option, but you havereceived a net credit for the trade by virtue of shorting the stock.
Steps In■
Try to ensure that the trend is downward and identify a clear area of resistance.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
If the stock falls by more than the call premium, then you’ll make a profit atexpiration.
■
If the stock rises above your stop loss, then exit by either reversing yourposition or simply buying back the stock and keeping the Long Call up to anew profit objective.
7.3.2 ContextOutlook■
With Synthetic Puts, your outlook is bearish.
Rationale■
To create the bearish risk profile of a put option but to take in a net credit byselling the stock short.
■
If the stock falls, you can make a profit.
■
If the stock rises, you will lose money, but your losses will be capped at thelevel of the call strike price to the call premium plus the difference between thestock price and call strike price.
Net Position■
If you’re trading stocks, this is a net credit trade.
■
Your maximum risk is limited if the stock rises.
Effect of Time Decay■
Time decay is harmful to the value of the call you bought.
Appropriate Time Period to Trade■
Buy the calls with as long a time to expiration as you need the short cover for, plusat least one extra month so that you can avoid the worst effects of time decay.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Try to ensure that the trend is downward and identify a clear area of resistance.
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Selecting the Options■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Strike—Look for either the ATM or just OTM (higher) strike above the currentstock. If you’re confident of the stock falling, then choose a higher strike call; ifyou want maximum short cover, choose the ATM strike call, which will bemore expensive.
■
Expiration—Depends on how long you want the short cover insurance for. Ifit’s just to get past an earnings report, then just buy enough time to cover thatevent plus one more month to avoid the worst effects of time decay.
7.3.3 Risk Profile[Call strike price  stock price  call premium]
■
Maximum Risk
■
Maximum Reward [Stock price  call premium]
■
Breakeven
[Stock price  call premium]
7.3.4 GreeksKey:ExpirationToday – 6 monthsTime(t) – 1 monthRisk ProfileAs the stock falls, wemake profits. As thestock rises, our risk iscontained by thebought call.
Risk Profile
Theta
ThetaTime decay is harmfulto the positionbecause we are longin options.
DeltaDelta (speed) is negative and peaks as weget deep ITM.
Delta
Vega
VegaVolatility is helpful tothe position becausewe are long inoptions.
GammaGamma (acceleration)peaks positivelyaround the strikeprice.
Gamma
Rho
RhoHigher interest ratesare generally helpfulto the position.
Synthetic Strategies
7.3.5 Advantages and DisadvantagesAdvantages■
Replicate a put and profit from declining stocks with no capital outlay.
■
Limited risk if the stock rises.
■
Uncapped reward if the stock falls.
Disadvantages■
More complex than simply buying puts.
■
Time decay will erode the value of the call you buy, while buying a long-termcall will detrimentally affect your risk profile. Use the call as insurance againstthe stock rising.
7.3.6 Exiting the TradeExiting the Position■
If the share rises above the strike price, you will make a limited loss.
■
If the share falls below the stock price (plus premium you paid), you will makea profit.
■
For any exit, you can either buy the stock or sell the call or both. If the sharefalls and you believe that it may rise afterwards, then you can just buy thestock and wait for the call to regain some of its value before selling that, too.
Mitigating a Loss■
You have already mitigated your losses by buying the calls to insure your longstock position.
7.3.7 ExampleABCD is trading at $34.17 on June 1, 2004.Short 1,000 shares of stock at $34.17.Buy 10 August 2004 35 strike calls at $2.76.Net Credit
Stock price  premium bought$34.17  $2.76  $31.41$31,410
Maximum Risk
Call premium  call strike  stock price$2.76  $35.00  $34.17  $3.59$3,590
Maximum Reward
Stock price  premium bought$34.17  $2.76  $31.41$31,410
Breakeven
Stock price  premium bought$34.17  $2.76  $31.41
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Notice how low the maximum risk is: just $3,590 compared to the net credit of$31,410. That’s the effect of the insurance you’ve bought for only $2.76 (or $2,760).Now let’s see what would happen if we tried a higher strike call.Short 1,000 shares of stock at $34.17.Buy 10 August 2004 40 strike calls at $1.29.Net Credit
Stock price  premium bought$34.17  $1.29  $32.88$32,880
Maximum Risk
Call premium  call strike  stock price$1.29  $40.00  $34.17  $7.12$7,120
Maximum Reward
Stock price  premium bought$34.17  $1.29  $32.88$32,880
Breakeven
Stock price  premium bought$34.17  $1.29  $32.88
The higher call strike is cheaper, but it gives us less insurance. Our breakeven is alsofriendlier with the higher call strike trade, so you should buy as much insurance asyou think you’ll need. The more insurance you require, the more expensive it willbe, but the less risk you’ll be taking.
7.4 Long Call Synthetic StraddleProficiency
Direction
Volatility
Asset Legs
Max Risk
Max Reward
Strategy Type
Uncapped
Capital Gain
!
Expert
Neutral
High
■ Short Stock
Capped
■ Two Long Calls
7.4.1 DescriptionStraddles can be created “synthetically”—in other words, instead of buying calls andputs together, we create the same risk profile by combining calls or puts with a longor short position in the stock.The Long Call Synthetic Straddle involves buying calls and counteracting themwith a short stock position. To create the straddle shape, we must buy twice the number of calls. So for every 100 shares we short, we must buy two call contracts, whichrepresent 200 shares of the stock. You may notice that the Long Call Synthetic Straddleis similar to the Synthetic Call, except that here we buy twice the number of calls.
Sell stock
Buy two calls
Long Call Synthetic Straddle
Synthetic Strategies
Steps to Trading a Long Call Synthetic Straddle1. Short the stock (if trading U.S. stocks, sell 50 shares for every call contract youbuy).2. Buy two ATM calls per 100 shares you sell. If the current stock price isn’t nearthe nearest strike price, then it’s better to choose the nearest ITM strike (lowerthan the current stock price).Steps In■
Actively seek chart patterns that appear like pennant formations, signifyinga consolidating price pattern.
■
Try to concentrate on stocks with news events and earnings reports aboutto happen within two weeks.
■
Choose a stock price range you feel comfortable with. Some traders prefer amiddle range between $20.00 and $60.00.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
Exit either a few days after the news event occurs if there is no movementor after the news event if there has been profitable movement.
■
If the stock thrusts up, sell the calls (making a profit for the entire position)and wait for a retracement to profit from the short stock.
■
If the stock thrusts down, buy back the stock (making a profit for the entireposition) and wait for a retracement to profit from the calls.
■
Try to avoid holding the option into the last month; otherwise, you’ll beexposed to serious time decay.
7.4.2 ContextOutlook■
With a long Synthetic Straddle, your outlook is neutral in terms of direction,but you’re looking for increasing volatility in the stock so that the stock pricemoves beyond your breakeven points on either side.
Rationale■
To execute a net credit direction neutral trade, where you expect the stock tobehave with increasing volatility in either direction.
■
If the stock rises explosively, you will make money from your calls, which risefaster than your short stock position falls.
■
If the stock falls, you will make profit from your short stock position, whichincreases in value faster than your calls lose value beyond the price you paidfor the calls.
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Net Position■
If you’re trading stocks, this is a net credit trade because you are selling thestock and paying only a fraction of that credit for the Long Call options.
■
Your maximum risk is limited if the stock rises.
Effect of Time Decay■
Time decay is harmful to the value of your Long Calls. You need time for thestock to move explosively.
Appropriate Time Period to Trade■
We want to combine safety with prudence on cost. Therefore, the optimumtime period to trade straddles is with three months until expiration, but if thestock has not moved decisively, sell your position when there is one month toexpiration. Be wary of holding a Straddle into the last month.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Actively seek chart patterns that appear like pennant formations, signifying aconsolidating price pattern.
■
Try to concentrate on stocks with news events and earnings reports about tohappen within two weeks.
■
Choose a stock price range you feel comfortable with. For some traders, that’sbetween $20.00 and $60.00.
Selecting the Options■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Strike—As close to ATM as possible.
■
Expiration—Preferably around three months.
7.4.3 Risk Profile■
Maximum Risk
Limited to: [(contracts * value per point) / number ofsold shares] * [call premium paid]  [call strike price] [stock price sold]
■
Maximum Reward
[Uncapped]
■
Breakeven Down
[Stock price  (call premium * 2)]
■
Breakeven Up
[Stock price  (call premium * 2)]  [(2 * (stock price strike price))]
Synthetic Strategies
7.4.4 GreeksKey:ExpirationToday – 3 monthsTime(t) – 1 monthRisk ProfileIf the stock priceremains around thestrike price, we makeour maximum loss. If itmoves explosively ineither direction, wemake profits.
Risk Profile
Theta
ThetaTime decay is harmfulto the positionbecause we are longin options.
DeltaDelta (speed) is at itsgreatest when theposition is makingmoney in either direction. The negativeDelta is purely an indication of direction;i.e., making profit asthe stock falls.
Delta
Vega
VegaVolatility is helpful tothe position becausewe are long inoptions.
Gamma
Rho
RhoHigher interest ratesare generally helpfulto the position whenthe stock rises.
GammaGamma (acceleration)peaks positivelyaround the strikeprice.
7.4.5 Advantages and DisadvantagesAdvantages■
Profit from a volatile stock moving in either direction.
■
Capped risk.
■
Uncapped profit potential if the stock moves.
■
No capital outlay.
Disadvantages■
Significant movement of the stock and option prices is required to make aprofit.
■
Bid/Ask Spread can adversely affect the quality of the trade.
■
Psychologically demanding strategy.
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7.4.6 Exiting the TradeExiting the Position■
If the share has moved decisively, then you simply unravel the trade by sellingyour call options and buying back the stock.
Mitigating a Loss■
Unravel the position as described previously.
7.4.7 ExampleABCD is trading at $35.07 on June 2, 2004.Short 500 shares of stock at $35.07.Buy 10 August 2004 35 strike calls at $3.00.Net Credit
Stock price  (2 * premium bought)$35.07  $6.00  $29.07
Maximum Risk
[(Contracts * value per point) / number of sold shares] * callpremium paid]  [call strike price]  [stock price sold]([(10 * 100) / 500] * $3.00)  $35.00  $35.07  $5.93
Maximum Reward
Uncapped
Breakeven Down
Stock price  (2 * premium bought)$35.07  $6.00  $29.07
Breakeven Up
[Stock price  (call premium * 2)]  [(2 * (stock price  strikeprice))][$35.07  ($3.00 * 2)]  [(2 * ($35.07  $35.00))]  $40.93
7.5 Long Put Synthetic StraddleProficiency
Direction
Volatility
Asset Legs
Max Risk
Max Reward
Strategy Type
Uncapped
Capital Gain
!
Expert
Neutral
High
■ Long Stock
Capped
■ Two Long Puts
7.5.1 DescriptionAs we saw in Section 6.4, straddles can be created “synthetically.” In other words,instead of buying calls and puts together, we create the same risk profile by combining calls or puts with a long or short position in the stock.
Synthetic Strategies
The Long Put Synthetic Straddle involves buying puts and counteracting themwith a Long Stock position. To create the Straddle shape, we have to buy twice thenumber of puts. So for every 100 shares we buy, we have to buy two put contracts,which represent 200 shares of the stock. The Long Stock position replicates the actionof buying the same number of calls as puts. Because we’re buying stock to counteract the long puts in this case, the Long Put Synthetic Straddle is an expensive strategy, requiring a large net debit.
Buy stock
Buy two puts
Long Put Synthetic Straddle
Steps to Trading a Long Put Synthetic Straddle1. Buy the stock (if trading U.S. stocks, sell 50 shares for every put contract you buy).2. Buy two ATM puts per 100 shares you buy. If the current stock price isn’t nearthe nearest strike price, then it’s better to choose the nearest ITM strike (higherthan the current stock price).Steps In■
Actively seek chart patterns that appear like pennant formations, signifyinga consolidating price pattern.
■
Try to concentrate on stocks with news events and earnings reports aboutto happen within two weeks.
■
Choose a stock price range you feel comfortable with. Some traders prefer amiddle range between $20.00 and $50.00.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
Exit either a few days after the news event occurs if there is no movement,or after the news event if there has been profitable movement.
■
If the stock thrusts up, sell the stock (making a profit for the entire position)and wait for a retracement to profit from the puts.
■
If the stock thrusts down, sell the puts (making a profit for the entire position) and wait for a retracement to profit from the stock.
■
Never hold into the last month.
7.5.2 ContextOutlook■
With a long Synthetic Straddle, your outlook is neutral in terms of direction,but you’re looking for increasing volatility in the stock so that the stock pricemoves beyond your breakeven points on either side.
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Rationale■
To execute a direction neutral trade where you expect the stock to behave withincreasing volatility in either direction.
■
If the stock rises explosively, you will make money from your long stock position, which will rise faster than your Long Put position falls.
■
If the stock falls, you will profit from your Long Put position, which willincrease in value faster than your long stock position loses value beyond theprice you paid for the puts.
Net Position■
This is a net debit trade because you are buying the stock and the puts.
Effect of Time Decay■
Time decay is harmful to the value of your Long Puts. You need time for thestock to move explosively.
Appropriate Time Period to Trade■
We want to combine safety with prudence on cost. Therefore, the optimumtime period to trade straddles is with three months until expiration, but if thestock has not moved decisively, you should sell your position when there isone month to expiration. Be wary of holding a Straddle into the last month.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Actively seek chart patterns that appear like pennant formations, signifying aconsolidating price pattern
■
Try to concentrate on stocks with news events and earnings reports about tohappen within two weeks.
■
Choose a stock price range you feel comfortable with. For some traders, that’sbetween $20.00 and $50.00.
Selecting the Options■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Strike—As close to ATM as possible.
■
Expiration—Preferably around three months.
Synthetic Strategies
7.5.3 Risk Profile■
Maximum Risk
■
Maximum Reward [Uncapped]
■
Breakeven Down
[Put strike  (put premium * 2)]  [(put strike  stock price)]
■
Breakeven Up
[Stock price  (2 * put premium)]
Limited to: [((contracts * value per point) / number ofbought shares] * put premium paid)]  [stock price] [put strike price]
7.5.4 GreeksKey:ExpirationToday – 3 monthsTime(t) – 1 monthRisk ProfileIf the stock priceremains around thestrike price, we makeour maximum loss. If itmoves explosively ineither direction, wemake profits.
Risk Profile
Theta
ThetaTime decay is harmfulto the positionbecause we are longin options.
DeltaDelta (speed) is at itsgreatest when theposition is makingmoney in either direction. The negativeDelta is purely an indication of direction;i.e., making profit asthe stock falls.
Delta
Vega
VegaVolatility is helpful tothe position becausewe are long inoptions.
Gamma
Rho
RhoHigher interest ratesare generally unhelpful to the positionwhen the stock falls.
GammaGamma (acceleration)peaks positivelyaround the strikeprice.
7.5.5 Advantages and DisadvantagesAdvantages■
Profit from a volatile stock moving in either direction.
■
Capped risk.
■
Uncapped profit potential if the stock moves.
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Disadvantages■
Significant movement of the stock and option prices is required to make a profit.
■
Bid/Ask Spread can adversely affect the quality of the trade.
■
Psychologically demanding strategy.
■
Expensive.
7.5.6 Exiting the TradeExiting the Position■
If the share has moved decisively, then you simply unravel the trade by sellingyour put options and the stock.
Mitigating a Loss■
Unravel the position as described previously.
7.5.7 ExampleABCD is trading at $35.07 on June 2, 2004.Buy 500 shares of stock at $35.07.Buy 10 August 2004 35 strike puts at $2.85.Net Debit
Stock price  (2 * put premium)$35.07  $5.70  $40.77
Maximum Risk
[((Contracts * value per point) / number of bought shares] *put premium paid)]  [stock price]  [put strike price][(10 * 100) / 500] * $2.85)  $35.07  $35.00  $5.77
Maximum Reward
Uncapped
Breakeven Down
[Put strike  (put premium * 2)]  [(put strike  stockprice)]$35.00  $5.70  ($35.00  $35.07)  $29.23
Breakeven Up
[Stock price  (put premium * 2)][$35.07  $5.70]  $40.77
Let’s compare the results of the Long Put Synthetic Straddle with the Long CallSynthetic Straddle.Long Put Synthetic Straddle
Long Call Synthetic Straddle
Net Debit / Net Credit
$40.77 net debit
$29.07 net credit
Maximum Risk
$5.77
$5.93
Maximum Reward
Uncapped
Uncapped
Breakeven Down
$29.23
$29.07
Breakeven Up
$40.77
$40.93
Synthetic Strategies
As we can see, the Long Put version is more expensive but has slightly less risk, andalso the breakevens are narrower, which is preferable for Long Straddles.If we had the choice of the two here, we’d be more inclined to go with the longput version, even if it means a net debit.
7.6 Short Call Synthetic StraddleProficiency
Direction
Volatility
Asset Legs
Max Risk
Max Reward Strategy Type
Expert
Neutral
Low
■ Long Stock
Uncapped Capped
Capital Gain
■ Two Short Calls
7.6.1 DescriptionWe know that straddles can be created “synthetically.” Well, so can short straddles,though I wouldn’t recommend them for inexperienced traders.Instead of selling calls and puts together, we create the same risk profile by combining short calls or puts with a long or short position in the stock.The Short Call Synthetic Straddle involves selling calls and counteracting themwith a long stock position. To create the short straddle shape, we have to sell twicethe number of calls. So for every 100 shares we buy, we have to sell two call contracts, which represent 200 shares of the stock.
Buy stock
Sell two calls
Short Call Synthetic Straddle
Steps to Trading a Short Call Synthetic Straddle1. Buy the stock (if trading U.S. stocks, sell 50 shares for every call contract youbuy).2. Sell two ATM calls per 100 shares you sell. If the current stock price isn’t nearthe nearest strike price, then it’s better to choose an OTM strike (higher thanthe current stock price).Steps In■
Try to ensure that the trend is rangebound and identify clear areas of support and resistance.
■
Try to ensure that no news is coming out imminently for the stock.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
Close the losing side by unraveling the relevant side if the stock breaks ineither direction.
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Unravel the entire trade if the position is profitable and you think newsmay emerge about the underlying stock.
7.6.2 ContextOutlook■
With a Short Synthetic Straddle, your outlook is direction neutral—you arelooking for no movement in the stock and reducing volatility.
Rationale■
To execute a direction neutral trade where you expect the stock to be rangebound and behave with reduced volatility.
Net Position■
If you’re trading stocks, this is a net debit transaction because you are buyingthe stock and receiving only a fraction of that credit for the Short Call options.
■
Your maximum risk is uncapped if the stock moves explosively in eitherdirection.
■
Your maximum reward is capped and occurs at the strike price.
Effect of Time Decay■
Time decay is helpful to your Short Call position.
Appropriate Time Period to Trade■
One month or less.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Try to ensure that the trend is rangebound and identify clear areas of supportand resistance.
■
Try to ensure that no news is coming out imminently for the stock.
Selecting the Options■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Strike—As close to ATM as possible, but preferably slightly OTM (higher thanthe current stock price).
■
Expiration—Preferably one month or less.
Synthetic Strategies
7.6.3 Risk Profile■
Maximum Risk
[Uncapped]
■
Maximum Reward
[((Contracts * value per point) / number of boughtshares) * call premium]  [call strike price]  [stockprice]
■
Breakeven Down
[Stock price  (call premium * 2)]
■
Breakeven Up
[Stock price  (call premium * 2)]  [(2 * (stock price strike price))]
7.6.4 GreeksKey:ExpirationToday – 1 monthTime(t) – 5 daysRisk ProfileIf the stock priceremains around thestrike price, we makeour maximum profit.If it moves explosivelyin either direction, wemake uncappedlosses.
Risk Profile
Theta
ThetaTime decay is helpfulto the positionbecause we are shortin options.
DeltaDelta (speed) is at itsgreatest when theposition is losingmoney in either direction. The negativeDelta is purely an indication of direction.
Delta
Vega
VegaVolatility is harmful tothe position becausewe are short inoptions.
Gamma