Synthetic Short Stock (Split Strikes) Explained

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Synthetic Short Stock (Split Strikes) Explained

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.

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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.

Does using a synthetic short futures split strike position in trading options involve margin money ?

Wiki User
March 14, 2020 7:12AM

No. It involves a great deal of courage and knowledge of the

market’s direction, though.

This strategy involves selling slightly out-of-the-money calls,

and buying an equal number of slightly out-of-the-money puts on the

same underlying futures.

Example: Acme is trading at 30. You think it’s going to trade at

7 next month. So, you sell a call at 35, and buy a put at 25. We

will say the premium on both ends of this is the same, which keeps

us from having to calculate premiums into the losses and gains.

If Acme trades at 28 next month, or 32 or any number between

$24.95 and $35.05, both options expire worthless.

If Acme trades at 20 next month, the call will expire worthless

and the put will net you $5 per share. Options are written against

100 stocks, so you pick up $500. (If it really did drop to 7, you’d

make a lot of money.)

The problem is, Acme might trade at 50 next month. If you blow

it that badly, it will cost you $5000 ($50 x 100 shares) to pay off

Margin is buying stocks on credit, and you couldn’t use it to

pay off that call.

Fun fact: this system of buying puts and selling calls is how

the Madoff ponzi scheme was billed as working.

The Short-term Performance of Stock Split

Do you want to read the rest of this article?

Stock Splits

Stock Splits Definition

Stock split, also known as share split, is the way through which the companies divide their existing outstanding shares into multiple shares such as 3 shares for every 1 share held or 2 shares for every 1 held etc. Market capitalization of the company during stock split remains the same, even though the number of shares increases, there is a corresponding decrease in price per share.

Did you wonder when Yes Bank Share prices reduced by 80% on 21 September 2020? It was an example of a share split by the Bank. Yes bank split the shares in the ratio of 5 for 1 on the above date.

In this case, the total number of outstanding shares of the bank increased by 5 times and share price reduced by the same extent, thereby leaving Market Capitalisation at the same figure of Rs. 85,753.14 Crs.

Types of Stock Splits

There are two types –

  1. Forward Splits
  2. Reverse Splits

Above example of Yes bank is that of Forward splits. In an exactly opposite manner, if a company decides to reduce the outstanding number of shares and thereby increasing the share price proportionately, it becomes Reverse Stock Splits.

Stock Split 2 for 1

Stock Split 2 for 1 essentially means that there will now be two shares instead of 1. For example, if there were 100 shares and the issued price was $10, with the market capitalization of 100 x $10 = $1,000. If the company splits for 2 for 1, then the total number of shares will double to 200. The effective share price will be $1000/200 (Market cap/shares) = $5 per share.

2 for 1 Example

  • We note from below that Jewett-Cameron announces 2 for 1 Stock Split.
  • Management believes that the share split is expected to increase the liquidity of shares and will facilitate any new repurchase program in the future.
  • Also, the 2 for 1 stock split will result in doubling the number of shares to 4,468,988

Stock Split 3 for 1

Stock Split 3 for 1 means that there will three shares now instead of 1 share. For example, if there were 100 shares and the issued price was $10, with the market capitalization of 100 x $10 = $1,000. If the company splits for 3 for 1, then the total number of shares will triple to 300 shares. The effective share price will be $1000/300 (Market cap/shares) = $3.33 per share.

3 for 1 Example

  • Cameo Resources Corp has planned a 3 for 1 Stock Split.
  • Post 3 for 1 split Cameo will have 55,674,156 shares outstanding.

Stock Split 3 for 2

Stock Split 3 for 2 means that there will three shares for every two shares. For example, if there were 200 shares and the issued price was $20, with the market capitalization of 200 x $20 = $4,000. If the company splits for 3 for 2, then the total number of shares will now become 300 shares. The effective share price will be 4000/300 (Market cap/shares) = $13.33 per share.

3 for 2 Example

  • Horizon Bancorp Inc has planned for a 3-for-2 Stock Split.
  • 3 for 2 split will increase Horizon’s outstanding shares from approximately 25.6 million shares prior to the split to approximately 38.4 million shares

Reasons for Share Splits

Primarily the splits announced after a long run-up in the share price of the company. The main reason is to reduce the share price so that it is affordable for retail investors and thereby increase the investor base. This results in a renewal of investor interest of the company which has a positive effect on the share price in the short term. For example, the Yes Bank stock had risen by about 29% since the share splits announced in July 2020 till the actual split in September 2020.

Also, it enhances the liquidity in the market as the number of shares is increased. High liquidity results in an efficient market with the low bid-ask spread.

Typical reasons for reverse splits would increase the number of share price so as to maintain minimum share price as per listing criteria of some of the global stock markets like New York Stock Exchange. It requires that a stock should be trading for at least $1 a share.

Significance of Share Splits for Investors

  1. In case of forward splits, shares are now more affordable to investors. Those who are already invested does not benefit apart from an increase in a number of shares, however since the price of share also decreases, the overall value for them remains same.
  2. Future Earning per share (EPS) may reduce as numbers of shares are increasing. However, for existing investor, there may not be any impact as his existing numbers of shares are also increasing.
  3. For a Share split of a blue-chip company, there is a positive perception about further growth of the stock price to pre-split levels during the growth phase of the company.
  4. Share splits are tax neutral. There is no flow of money during share splits hence there are no tax implications due to this.
  5. In case of reverse sh splits, investors need to judge the reason for the same and if the same is for avoiding delisting of stock from the exchange, it may be perceived as negative.

Significance

  1. In case of forward stock splits, the number of shares increases hence the ownership base of the company increases. The shares can now be owned by a wide range of investors.
  2. Liquidity of the stock increases, thereby increasing the market efficiency of the stock.
  3. There is no change in Authorised and Issued capital of the company as it remains the same.
  4. In case of reverse share splits, the company can sideline penny stock traders as the price of the share increases.

Stock Splits vs Bonus issue

  1. The bonus issue is similar to forward splits in a way that share price decreases and the number of shares increase in both cases.
  2. In case of bonus issue, the company gives additional shares to its shareholders from its free reserves instead of issuing dividends. However in case of a share split, there is no such fresh issue, it is just manipulation of already issued capital.
  1. From an accounting perspective, in case of bonus issue, as shown above, the company issues fresh shares at same face value and transfers free reserve capital to issued share capital. In the case of share splits, free reserves and issued capital remain the same.
  2. Among bonus issue and stock splits, bonus issue may be perceived as more positive as the company is issuing more shares to shareholders from its free reserves. This can be perceived as signaling from management to investors that they are confident of more growth in the future.

Conclusion

A stock splits is a change (increase or decrease) in a number of outstanding shares of a company by proportionately changing (decreasing or increasing) the stock price so that overall Market Capitalisation remains the same.

Stock Splits Video

This has been a guide to Stock Splits. Here we discuss what are 2 for 1, 3 for 1 and 3 for 2 Share Splits along with practical examples. Also, we discuss share split reasons with respect and its significance to investors and the company. You may also have a look at the following articles on Corporate Finance –

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