Gamma (acceleration)peaks inverselyaround the strikeprice.
Gamma
Rho
RhoHigher interest ratesare generally unhelpful to the positionwhen the stock rises.
7.6.5 Advantages and DisadvantagesAdvantages■
Profit from a rangebound stock.
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Disadvantages■
Uncapped risk if the stock moves in either direction.
■
Capped reward.
■
Expensive trade because you have to buy the stock.
■
High-risk strategy, not for novices or intermediates.
7.6.6 Exiting the TradeExiting the Position■
If the stock remains below the call strike, then the short options will expireworthless at expiration, and you will keep the premium. You can then either sellthe stock or re-create the position with next month’s sold calls. Alternatively,you can set up another strategy involving being long in the stock.
Mitigating a Loss■
If the stock moves explosively upwards before expiration, you will be exercised,meaning that you will have to deliver double the amount of stock you hold.
■
At the beginning of the trade, you will have predefined your stop loss areas.
■
If the stock hits the upper price band, triggering your stop loss, then youshould buy back at least one of the calls. You will then have created a “coveredcall.” Alternatively, you can unravel the entire spread.
■
If the stock hits the lower price band, triggering your stop loss, then youshould sell the stock, provided that your account permits you to trade nakedoptions. Alternatively, you can unravel the entire spread by buying back thesold calls and selling the bought stock.
7.6.7 ExampleABCD is trading at $35.07 on June 2, 2004.Buy 500 shares of stock at $35.07.Sell 10 June 2004 35 strike calls at $1.55.Net Debit
Stock price  (2 * premium bought)$35.07  $3.10  $31.97
Maximum Risk
Uncapped
Maximum Reward
[((Contracts * value per point) / number of bought shares] * callpremium)  [call strike price]  [stock price][((10 * 100) / 500) * $1.55]  [$35.00  $35.07]  $3.03
Breakeven Down
Stock price  (2 * premium bought)$35.07  $3.10  $31.97
Breakeven Up
[Stock price  (call premium * 2)]  [(2 * (stock price  strike price))][$35.07  ($1.55 * 2)]  [(2 * ($35.07  $35.00))]  $38.03
Synthetic Strategies
7.7 Short Put Synthetic StraddleProficiency
Direction
Volatility
Asset Legs
Max Risk
Max Reward
Strategy Type
Uncapped
Capped
Income
Expert
Neutral
Low
■ Short Stock■ Two Short Puts
7.7.1 DescriptionAs we just saw in Section 6.6, we can create Short Straddles synthetically, thoughagain, I wouldn’t necessarily recommend it for inexperienced traders.The Short Put Synthetic Straddle involves selling puts and counteracting themwith a Short Stock position. To create the Short Straddle shape, we have to sell twicethe number of puts. So for every 100 shares we sell, we have to sell two put contracts,which represent 200 shares of the stock.This strategy creates a large net credit in our accounts and as such can be considered an income strategy.
Sell stock
Sell two puts
Short Put Synthetic Straddle
Steps to Trading a Short Put Synthetic Straddle1. Sell the stock (if trading U.S. stocks, sell 50 shares for every put contract youbuy).2. Sell two ATM calls per 100 shares you buy. 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 TradingPlan.
■
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.
7.7.2 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 berangebound and behave with reduced volatility.
Net Position■
This is a net credit trade because you are selling both the stock and the putoptions, thereby receiving money into your account.
■
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 put 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.
Synthetic Strategies■
Strike—As close to ATM as possible, but preferably slightly OTM (lower thanthe current stock price).
■
Expiration—Preferably one month or less.
7.7.3 Risk Profile■
Maximum Risk
[Uncapped]
■
Maximum Reward
[((Contracts * value per point) / number of sold shares) *put premium sold]  [stock price sold  put strikeprice]
■
Breakeven Down
[Stock price (2 * put premium)]
■
Breakeven Up
[Stock price  (2 * put premium)]  [2 * (stock price put strike)]
7.7.4 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
DeltaDelta (speed) is at itsgreatest when theposition is losingmoney in either direction. The negativeDelta is purely an indication of direction.
Delta
Vega
GammaGamma (acceleration)peaks inverselyaround the strikeprice.
Gamma
Rho
ThetaTime decay is helpfulto the positionbecause we are shortin options.
VegaVolatility is harmful tothe position becausewe are short inoptions.
RhoHigher interest ratesare generally helpfulto the position whenthe stock falls.
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7.7.5 Advantages and DisadvantagesAdvantages■
Profit from a rangebound stock.
■
No capital outlay.
■
Substantial net credit received.
Disadvantages■
Uncapped risk if the stock moves in either direction.
■
Capped reward.
■
High-risk strategy, not for novices or intermediates.
7.7.6 Exiting the TradeExiting the Position■
If the stock remains above the put strike, then the short options will expireworthless at expiration, and you will keep the premium. You can then eitherbuy back the stock or re-create the position with next month’s sold puts.Alternatively, you can set up another strategy involving being short in the stock.
Mitigating a Loss■
If the stock moves explosively downwards before expiration, you will be exercised at that time, meaning that you will have to buy double the amount ofstock you shorted.
■
At the beginning of the trade, you will have set your stop loss.
■
If the stock hits the upper price band, triggering your stop loss, then youshould consider buying back the stock. You will then be short in two puts,which you may have to buy back or hedge in order to avoid an unlimited riskposition. Alternatively, you can simply unravel the entire spread.
■
If the stock hits the lower price band, triggering your stop loss, then youshould buy back your sold puts. If you buy back just half of your sold puts,you will have created a “Covered Put” risk profile. However, this still exposesyou to unlimited losses, so it is best to simply unravel the entire position andtake your stop loss.
7.7.7 ExampleABCD is trading at $35.07 on June 2, 2004.Sell 500 shares of stock at $35.07.Sell 10 June 2004 35 strike puts at $1.25.
Synthetic Strategies
Net Credit
Stock price  (2 * premium bought)$35.07  $2.50  $37.57
Maximum Risk
Uncapped
Maximum Reward
[((Contracts * value per point) / number of sold shares) * putpremium]  [stock price  put strike price][(10 * 100) / 500) * $1.25]  [$35.07  $35.00]  $2.57
Breakeven Down
Stock price  (2 * put premium)$35.07  $2.50  $32.57
Breakeven Up
[Stock price  (2 * put premium)]  [2 * (stock price  putstrike)][$35.07  ($1.25 * 2)]  [(2 * ($35.07  $35.00))]  $37.43
Let’s compare the results of the Short Put Synthetic Straddle with the Short CallSynthetic Straddle.Short Put Synthetic Straddle
Short Call Synthetic Straddle
Net Debit / Net Credit
$37.57 net credit
$31.97 net debit
Maximum Risk
Uncapped
Uncapped
Maximum Reward
$2.57
$3.03
Breakeven Down
$32.57
$31.97
Breakeven Up
$37.43
$38.03
As we can see, the Short Call version is more expensive but has slightly less risk, andalso the breakevens are wider apart, which is preferable for short straddles.If we had the choice of the two here, we’d be more inclined to go with the ShortCall version, even if it means a net debit.
7.8 Long Synthetic FutureProficiency
Direction
VolatilityN/A
Expert
Bullish
Asset Legs
Max Risk
Max Reward
Strategy Type
Uncapped
Uncapped
Capital Gain
■ Short Put■ Long Call
7.8.1 DescriptionWe can synthetically create the risk profile or a long stock by selling ATM puts andbuying ATM calls. The net result is a very inexpensive, nil cost, or even net credittrade that precisely mimics the long stock or long future position.
Sell put
Buy call
Long Synthetic Future
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Steps to Trading a Long Synthetic Future1. Sell an ATM put.2. Buy an ATM call with the same strike and expiration date.Steps In■
Try to ensure that the trend is upward and identify a clear area of support.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
Play the strategy just as you would if you’d simply bought the stock. Thedifference is that with a Long Synthetic Future, you can leg out of the trade,maximizing your trading opportunity.
■
Never hold the long option into the last month before expiration.
7.8.2 ContextOutlook■
With Long Synthetic Futures, your outlook is bullish.
Rationale■
To simulate the action of buying a stock, but to do so with a fraction of thecost. This also simulates the action of taking a long position in a future.
Net Position■
This is usually a net debit trade. It can depend on how close the strike price isto the stock price and whether it is above or below the stock price.
■
Your risk on the trade itself is uncapped on the downside until the stock fallsdown to zero.
Effect of Time Decay■
Time decay is harmful to your Long Synthetic Future trade, but with this strategy, you are hedging time decay by buying and selling near the moneyoptions, so the effect is minimal. What you lose from the Long Call time value,you benefit from the Short Put position.
Appropriate Time Period to Trade■
Generally, you will be using this strategy in conjunction with another trade. Itis generally more sensible to use this as a longer-term trade.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Try to ensure that the trend is upward and identify a clear area of support.
Synthetic Strategies
Selecting the Options■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Strike—As close to ATM as possible (same for both legs).
■
Expiration—Any time period can work, though remember that the long callwill suffer from time decay, particularly in the final month to expiration, so it’sbest to choose expirations of two months or more. Use the same expiration forboth legs.
7.8.3 Risk Profile■
Maximum Risk
[Strike price  net debit]
■
Maximum Reward
[Uncapped]
■
Breakeven
[Strike price  net debit]
7.8.4 GreeksKey:ExpirationToday – 6 monthsTime(t) – 1 monthRisk ProfileAs the stock pricerises, we make profitsand vice versa.
Risk Profile
Theta
ThetaTime decay is generally harmful to theposition becauseof the long callcomponent.
DeltaDelta (speed) is constant. As the stockmoves $1.00, so doesthe long syntheticfuture position . . . atleast in theory!
Delta
Vega
VegaVolatility is constantand will depend onthe distance of theoptions to the strikeprice.
GammaThere is no acceleration because Delta isconstant. Therefore,Gamma is zero.
Gamma
Rho
RhoRho is positive andconstant. As with theother Greeks, in relation to this strategy,it is relativelymeaningless.
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7.8.5 Advantages and DisadvantagesAdvantages■
Create a long stock position with virtually zero capital outlay.
■
Capped risk down to the stock falling to zero (though this could be argued theother way too; i.e., uncapped risk down to zero!).
■
Uncapped profit potential if the stock appreciates.
Disadvantages■
No leverage or protection created by the position.
■
No dividend entitlement.
■
Bid/Ask Spread can adversely affect the quality of the trade.
7.8.6 Exiting the TradeExiting the Position■
With this strategy, you can simply unravel the spread by selling your calls andbuying back the puts.
■
You can also exit just your profitable leg of the trade and hope that the stockmoves to favor the unprofitable side later on. For example, if the share hasmoved decisively upwards, thus making the Long Calls profitable, you willsell the calls and make a profit on the entire trade, but you will be left withalmost valueless Short Puts. Having now sold the calls, you will secure yourposition by buying back the depleted puts.
Mitigating a Loss■
Sell the position if the stock breaks down through your predetermined stoploss.
7.8.7 ExampleABCD is trading at $35.69 on June 2, 2004.Sell November 2004 35 strike puts at $3.60.Buy November 2004 35 strike calls at $4.60.Net Debit
[Bought call  sold put]$4.60  $3.60  $1.00
Maximum Risk
[Strike price  net debit]$35.00  $1.00  $36.00
Maximum Reward
Uncapped
Breakeven
[Strike price  net debit]$35.00  $1.00  $36.00
Synthetic Strategies
7.9 Short Synthetic FutureProficiency
Direction
VolatilityN/A
Expert
Bearish
Asset Legs
Max Risk
Max Reward
Strategy Type
Uncapped
Uncapped
Capital Gain
■ Long Put■ Short Call
7.9.1 DescriptionThe precise opposite of a Long Synthetic Future, we can synthetically create the riskprofile or a short stock position by buying ATM puts and selling ATM calls. The netresult is a virtually nil cost or even net credit trade that precisely mimics the shortstock or short future position.
Buy put
Sell call
Short Synthetic Future
Steps to Trading a Short Synthetic Future1. Buy an ATM put.2. Sell an ATM call with the same strike and expiration date.Steps In■
Try to ensure that the trend is downward and identify a clear area ofresistance.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
Play the strategy just as you would if you’d simply shorted the stock. Thedifference is that with a Short Synthetic Future, you can leg out of the trade,maximizing your trading opportunity.
■
Never hold the long option into the last month before expiration.
7.9.2 ContextOutlook■
With Short Synthetic Futures, your outlook is bearish.
Rationale■
To simulate the action of shorting a stock. This also simulates the action oftaking a short position in a future.
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Net Position■
This is usually a net credit trade. It can depend on how close the strike price isto the stock price and whether it is above or below the stock price.
■
Your risk on the trade itself is uncapped on the upside as the stock rises.
Effect of Time Decay■
Time decay helps your Short Synthetic Future trade, but with this strategy, youare hedging time decay by buying and selling near the money options, so theeffect is minimal. What you lose from the Long Put time value, you benefitfrom the Short Call position.
Appropriate Time Period to Trade■
Generally, you will be using this strategy in conjunction with another trade.It is generally more sensible to use this as a shorter-term trade, though atthe same time you should consider the effect of time decay on the long putleg.
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 ofresistance.
Selecting the Options■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Strike—As close to ATM as possible (same for both legs).
■
Expiration—Any time period can work, though remember that the Long Putwill suffer from time decay, particularly in the final month to expiration, so it’sbest to choose expirations of two months or more. Use the same expiration forboth legs.
7.9.3 Risk Profile■
Maximum Risk
[Uncapped]
■
Maximum Reward
[Strike price  net credit] (or  net debit)
■
Breakeven
[Strike price  net credit] (or  net debit)
Synthetic Strategies
7.9.4 GreeksKey:ExpirationToday – 6 monthsTime(t) – 1 monthRisk ProfileAs the stock pricefalls, we make profitsand vice versa.
Risk Profile
Theta
ThetaTime decay is generally helpful to theposition becauseof the short callcomponent.
DeltaDelta (speed) is constant. As the stockmoves $1.00 in onedirection, the longsynthetic future position moves the sameamount in the otherdirection . . . at leastin theory!
Delta
Vega
VegaVolatility is constantand will depend onthe distance of theoptions to the strikeprice.
Gamma
Rho
RhoRho is negative andconstant. As with theother Greeks, in relation to this strategy,it is relatively meaningless.
GammaThere is no acceleration because Delta isconstant. Therefore,gamma is zero.
7.9.5 Advantages and DisadvantagesAdvantages■
Create a short stock position with the ability to leg in and out of the call or putas appropriate.
■
Uncapped profit potential as the stock declines to zero (though this couldequally be described as being capped reward after the stock has fallen to zero!).
Disadvantages■
No leverage or protection created by the position.
■
Uncapped risk potential if the stock rises.
■
Bid/Ask Spread can adversely affect the quality of the trade.
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7.9.6 Exiting the TradeExiting the Position■
With this strategy, you can simply unravel the spread by selling your puts andbuying back the calls.
■
You can also exit just your profitable leg of the trade and hope that the stockmoves to favor the unprofitable side later on. For example, if the share hasmoved decisively downwards, thereby making the long puts profitable, youwill sell the puts and make a profit on the entire trade, but you will be left withalmost valueless short calls. Having now sold the puts, you will secure yourposition by buying back the depleted calls.
Mitigating a Loss■
Sell the position if the stock rises up through your predetermined stop loss.
7.9.7 ExampleABCD is trading at $35.38 on June 2, 2004.Buy August 2004 35 strike puts at $2.60.Sell August 2004 35 strike calls at $2.80.
Net Credit
[Sold call  bought put]$2.80  $2.60  $0.20
Maximum Risk
Uncapped
Maximum Reward
[Strike price  net credit]$35.00  $0.20  $35.20
Breakeven
[Strike price  net credit]$35.00  $0.20  $35.20
7.10 Long ComboProficiency
Direction
VolatilityN/A
Expert
Bullish
Asset Legs
Max Risk
Max Reward
Strategy Type
Uncapped
Uncapped
Capital Gain
■ Short Put■ Long Call
Synthetic Strategies
7.10.1 DescriptionThe Long Combo is a variation of the Long Synthetic Future. The only difference isthat we sell OTM (lower strike) puts and buy OTM (higher strike) calls.The net effect is an inexpensive trade, similar to a Long Stock or Long Futuresposition, except there is a gap between the strikes.
Sell put
Buy call
Long Combo
Steps to Trading a Long Combo1. Sell an OTM (lower strike) put.2. Buy an OTM (higher strike) call with the same expiration date.Steps In■
Try to ensure that the trend is upward and identify a clear area of support.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
Play the strategy just as you would if you’d simply bought the stock. Thedifference is that with a Long Combo, you can leg out of the trade,maximizing your trading opportunity.
■
Never hold the long option into the last month before expiration.
7.10.2 ContextOutlook■
With Long Combos, your outlook is bullish.
Rationale■
To simulate the action of buying a stock but to do so with a fraction of the cost.This also simulates the action of taking a long position in a future except forthe flat middle part between the strikes.
Net Position■
This is usually a net debit trade. It can depend on where the call and putstrikes are in relation to the stock price.
■
Your risk on the trade is uncapped on the downside until the stock falls downto zero.
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Effect of Time Decay■
Time decay is harmful to your Long Combo trade, but with this strategy, youare hedging time decay by buying and selling near the money options, so theeffect is minimal. What you lose from the Long Call time value, you benefitfrom the Short Put position.
Appropriate Time Period to Trade■
Generally, you will be using this strategy in conjunction with another trade. Itis generally more sensible to use this as a longer-term trade.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Try to ensure that the trend is upward and identify a clear area ofsupport.
Selecting the Options■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Put Strike—One strike OTM (lower than current stock price).
■
Call Strike—One strike OTM (higher than current stock price).
■
Expiration—Any time period can work, though remember that the long callwill suffer from time decay, particularly in the final month to expiration, so it’sbest to choose expirations of two months or more. Use the same expiration forboth legs.
7.10.3 Risk Profile■
Maximum Risk
[Lower strike  net debit]
■
Maximum Reward
[Uncapped]
■
Breakeven
With net debits: [higher strike  net debit]With net credits: [lower strike  net credit]
Synthetic Strategies
7.10.4 GreeksKey:ExpirationToday – 6 monthsTime(t) – 1 monthRisk ProfileAs the stock pricerises, we make profitsand vice versa.
Risk Profile
Theta
ThetaTime decay is helpfulwhen the position ismaking losses andgenerally harmfulwhen the positionruns into profit.
Delta
Vega
VegaVolatility is generallyhelpful when the position is profitable andharmful when it ismaking losses.
Gamma
Rho
RhoHigher interest ratesare generally helpfulto the position, moreso when there islonger to expiration.
DeltaDelta (speed) is positive, indicating thestrategy’s bullish bias.Remember, you’realmost replicating along stock positionhere, so Delta veers toone per contract whenthe underlying assetprice is deep OTMor ITM.GammaGamma (acceleration)peaks outside thestrike prices. Noticehow Gamma is neutralin between the strikes.
7.10.5 Advantages and DisadvantagesAdvantages■
Create something similar to a long stock position with virtually zero capitaloutlay.
■
Capped risk down to the stock falling to zero (though this could be argued theother way too; i.e., uncapped risk down to zero!).
■
Uncapped profit potential if the stock appreciates.
Disadvantages■
No leverage or protection created by the position.
■
No dividend entitlement.
■
Bid/Ask Spread can adversely affect the quality of the trade.
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7.10.6 Exiting the TradeExiting the Position■
With this strategy, you can simply unravel the spread by selling your calls andbuying back the puts.
■
You can also exit just your profitable leg of the trade and hope that the stockmoves to favor the unprofitable side later on. For example, if the share hasmoved decisively upwards, thereby making the Long Calls profitable, you willsell the calls and make a profit on the entire trade, but you will be left withalmost valueless short puts. Having now sold the calls, you will secure yourposition by buying back the depleted puts.
Mitigating a Loss■
Sell the position if the stock breaks down through your predetermined stoploss.
7.10.7 ExampleABCD is trading at $35.25 on June 2, 2004.Sell November 2004 30 strike puts at $1.65.Buy November 2004 40 strike calls at $2.35.Net Debit
[Bought call  sold put]$2.35  $1.65  $0.70
Maximum Risk
[Lower strike  net debit]$30.00  $0.70  $30.70
Maximum Reward
Uncapped
Breakeven
[Higher strike  net debit]$40.00  $0.70  $40.70
7.11 Short ComboProficiency
Direction
VolatilityN/A
Expert
Bearish
Asset Legs
Max Risk
Max Reward
Strategy Type
Uncapped
Uncapped
Capital Gain
■ Long Put■ Short Call
Synthetic Strategies
7.11.1 DescriptionThe Short Combo is the precise opposite of a Long Combo. Instead of nearly replicating the Long Stock (or Futures) position, we nearly replicate the Short Stock (orFutures) position by buying OTM puts and selling OTM calls.The net result is a virtually nil cost or even net credit trade that has uncapped riskpotential as the stock rises.
Buy put
Sell call
Short Combo
Steps to Trading a Short Combo1. Buy an OTM (lower strike) put.2. Sell an OTM (higher strike) call with the same expiration date.Steps In■
Try to ensure that the trend is downward and identify a clear area ofresistance.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
Play the strategy just as you would if you’d simply shorted the stock.The difference is that with a Short Combo, you can leg out of the trade,maximizing your trading opportunity.
■
Never hold the long option into the last month before expiration.
7.11.2 ContextOutlook■
With Short Combos, your outlook is bearish.
Rationale■
To simulate the action of shorting a stock. This also simulates the action of takinga short position in a future except for the flat middle part between the strikes.
Net Position■
This is usually a net credit trade. It can depend on how the strike prices arepositioned compared to the stock price.
■
Your risk on the trade itself is uncapped on the upside as the stock rises.
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Effect of Time Decay■
Time decay helps your Short Combo trade, but with this strategy, you arehedging time decay by buying and selling near the money options, so the effectis minimal. What you lose from the Long Put time value, you benefit from theShort Call position.
Appropriate Time Period to Trade■
Generally, you will be using this strategy in conjunction with another trade.It is generally more sensible to use this as a shorter-term trade, though atthe same time you should consider the effect of time decay on the LongPut leg.
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 ofresistance.
Selecting the Options■
Choose options with adequate liquidity; open interest should be at