Option Strategies When Market is BEARISH

7/24/2019 Option Strategies When Market is BEARISH

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Bear Call Spread

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The bear call spread option trading strategy is employed when the options trader thinks thatthe price of the underlying asset will go down moderately in the near term.

The bear call spread option strategy is also known as the bear call credit spread as a credit isreceived upon entering the trade.

Bear Call Spread Construction

Buy 1 OTM CallSell 1 ITM Call

Bear call spreads can be implemented by buyingcall optionsof a certainstrike priceandselling the same number of call options of lower strike price on the sameunderlying securityexpiring in the same month.

Bear Call Spread Payoff Diagram



Limited Downside Profit

The maximum gain attainable using the bear call spread options strategy is the credit receivedupon entering the trade. To reach the maximum profit, the stock price needs to close belowthe strike price of the lower striking call sold atexpiration datewhere both options wouldexpire worthless.

The formula for calculating maximum profit is given below:
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Max Profit = Net Premium Received - Commissions Paid Max Profit Achieved When Price of Underlying = Strike Price of Long Call

Breakeven Point(s)

The underlier price at which break-even is achieved for the bear call spread position can becalculated using the following formula.

Breakeven Point = Strike Price of Short Call + Net Premium Received

Bear Call Spread Example

Suppose XYZ stock is trading at $37 in June. An options trader bearish on XYZ decides to

enter a bear call spread position by buying a JUL 40 call for $100 and selling a JUL 35 callfor $300 at the same time, giving him a net $200 credit for entering this trade.

The price of XYZ stock subsequently drops to $34 at expiration. As both options expireworthless, the options trader gets to keep the entire credit of $200 as profit.

If the stock had rallied to $42 instead, both calls will expirein-the-moneywith the JUL 40call bought having $200 inintrinsic valueand the JUL 35 call sold having $700 in intrinsicvalue. The spread would then have a net value of $500 (the difference in strike price). Sincethe trader have to buy back the spread for $500, this means that he will have a net loss of$300 after deducting the $200 credit he earned when he put on the spread position.

Note: While we have covered the use of this strategy with reference to stock options, the bear

call spread is equally applicable using ETF options,index optionsas well asoptions on

futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take intoaccount commission charges as they are relatively small amounts (typically around $10 to$20) and varies acrossoption brokerages.
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However, for active traders, commissions can eat up a sizable portion of their profits in thelong run. If you trade options actively, it is wise to look for a low commissions broker.Traders who trade large number of contracts in each trade should check outOptionsHouse.comas they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Aggressive Bear Call Spread

One can enter a more aggressive bear spread position by widening the difference between thestrike price of the two call options. However, this will also mean that the stock price mustmove downwards by a greater degree for the trader to realise the maximum profit.

Bear Spread on a Debit

The bear call spread is acredit spreadas the difference between the sale and purchase of thetwo options results in a net credit. For a bearish spread position that is entered with a net

debit, seebear put spread.

Bear Put Spread



The bear put spread option trading strategy is employed when the options trader thinks thatthe price of the underlying asset will go down moderately in the near term.

Bear put spreads can be implemented by buying a higher strikingin-the-money put optionand selling a lower strikingout-of-the-money put optionof the same underlying security withthe sameexpiration date.

Bear Put Spread Construction

Buy 1 ITM PutSell 1 OTM Put

By shorting the out-of-the-money put, the options trader reduces the cost of establishing the

bearish position but forgoes the chance of making a large profit in the event that theunderlying asset price plummets. The bear put spread options strategy is also know as the

bear put debit spread as a debit is taken upon entering the trade.
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Bear Put Spread Payoff Diagram



Limited Downside Profit

To reach maximum profit, the stock price need to close below thestrike priceof the out-of-the-money puts on the expiration date. Both options expire in the money but the higher strike

put that was purchased will have higherintrinsic valuethan the lower strike put that was sold.

Thus, maximum profit for the bear put spread option strategy is equal to the difference instrike price minus the debit taken when the position was entered.


Max Profit = Strike Price of Long Put - Strike Price of Short Put - Net Premium Paid -Commissions Paid

Max Profit Achieved When Price of Underlying = Strike Price of Long Put

Breakeven Point(s)
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The underlier price at which break-even is achieved for the bear put spread position can becalculated using the following formula.

Breakeven Point = Strike Price of Long Put - Net Premium Paid

Bear Put Spread Example

Suppose XYZ stock is trading at $38 in June. An options trader bearish on XYZ decides toenter a bear put spread position by buying a JUL 40 put for $300 and sell a JUL 35 put for$100 at the same time, resulting in a net debit of $200 for entering this position.

The price of XYZ stock subsequently drops to $34 at expiration. Both puts expire in-the-money with the JUL 40 call bought having $600 in intrinsic value and the JUL 35 call soldhaving $100 in intrinsic value. The spread would then have a net value of $5 (the differencein strike price). Deducting the debit taken when he placed the trade, his net profit is $300.

This is also his maximum possible profit.

If the stock had rallied to $42 instead, both options expire worthless, and the options traderloses the entire debit of $200 taken to enter the trade. This is also the maximum possible loss.

Note: While we have covered the use of this strategy with reference to stock options, the bear

put spread is equally applicable using ETF options,index optionsas well asoptions on

futures.

Commissions



Bear Spread on a Credit

The bear put spread is adebit spreadas the difference between the sale and purchase of thetwo options results in a net debit. For a bearish spread position that is entered with a netcredit, seebear call spread.

Buying Index Puts

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The index long put is the simplest strategy to use in index options trading and theimplementation involves the purchase of an index put option.

Index Long Put ConstructionBuy 1 ATM Index Put

The options trader employing the index long put strategy believes that the underlying indexlevel will fall significantly below the put strike price within a certain period of time.

Unlimited Profit Potential

Since they can be no limit as to how low the index level can be at the option's expiration date,there is no limit to the maximum profit possible when implementing the index long put

strategy.

The formula for calculating profit is given below:

Maximum Profit = Unlimited

Profit Achieved When Index Settlement Value < Index Put Strike Price - PremiumPaid

Profit = Index Put Strike Price - Index Settlement Value - Premium Paid

Index Long Put Payoff Diagram



Limited Risk

Risk for the index long put strategy is capped and is equal to the price paid for the index putoption no matter how high the index is trading on expiration date.
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Breakeven Point(s)

The underlier price at which break-even is achieved for the index long put position can becalculated using the following formula.

Breakeven Point = Index Put Strike Price - Premium Paid

Example

XYZ Index is a broad based index representative of the entire stock market and its value inJune is 400. Believing that the broader market will retreat in the near future, an options trader

purchases an six-month XYZ index put with a strike price of $400 expiring in December for aquoted price of $4.00 per contract. With a contract multiplier of $100, the cost of the index

put option comes to $400.

Suppose XYZ Index dropped to 380 in December and the trader's DEC 400 XYZ index putexpires in-the-money. At settlement value of 380, the DEC 400 XYZ index put option willhave an intrinsic value of $20 and exercising this option will give the trader a settlementamount of $2000 ($20 x $100 contract multiplier). Taking into account the cost of the optionitself, which is $400, the trader's net profit comes to $1600.

Suppose XYZ Index went up to 420 in December and the trader's DEC 400 XYZ index putexpires out-of-the-money. At settlement value of 420, the DEC 400 XYZ index put optionwill expire worthless with zero intrinsic value. The trader's net loss is equal to the amount

paid for the index put option which is $400.

Commissions



Out-of-the-money Index Puts

Going long onout-of-the-money putsmaybe cheaper but the put options have higher risk ofexpiring worthless.

In-the-money Index Puts

In-the-money putsare more expensive than out-of-the-money puts but less amount is paid for

the option'stime value.
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Portfolio Insurance

Index puts can also be used toprotect a portfolioagainst a declining market without the needto liquidate any stock while at the same time enable the portfolio to participate and benefitfrom a rising market.

Covered Put



Writing covered puts is a bearish options trading strategy involving the writing ofput optionswhile shorting the obligated shares of theunderlying stock.

Covered Put Construction

Short 100 SharesSell 1 ATM Put

Limited profits with no downside risk

Profit for the covered put option strategy is limited and maximum gain is equal to thepremiumsreceived for the options sold.


Max Profit = Premium Received - Commissions Paid Max Profit Achieved When Price of Underlying


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Unlimited upside risk

As the writer is short on the stock, he is subjected to much risk if the price of the underlyingstock rises dramatically. In theory, maximum loss for the covered put options strategy isunlimited since there is no limit to how high the stock price can be at expiration. Ifapplicable, the covered put writer will also have to payout any dividends.

The formula for calculating loss is given below:

Maximum Loss = Unlimited Loss Occurs When Price of Underlying >= Sale Price of Underlying + Premium

Received

Loss = Price of Underlying - Sale Price of Underlying - Premium Received +Commissions Paid

Breakeven Point(s)

The underlier price at which break-even is achieved for the covered put position can becalculated using the following formula.

Breakeven Point = Sale Price of Underlying + Premium Received

ExampleSuppose XYZ stock is trading at $45 in June. An options trader writes a covered put byselling a JUL 45 put for $200 while shorting 100 shares of XYZ stock. The net credit taken toenter the position is $200, which is also his maximum possible profit.

On expiration in July, XYZ stock is still trading at $45. The JUL 45 put expires worthlesswhile the trader covers his short position with no loss. In the end, he gets to keep the entirecredit taken as profit.

If instead XYZ stock drops to $40 on expiration, the short put will expire in the money and is

worth $500 but this loss is offset by the $500 gain in the short stock position. Thus, the profitis still the initial credit of $200 taken on entering the trade.

However, should the stock rally to $55 on expiration, a significant loss results. At this price,the short stock position taken when XYZ stock was trading at $45 suffers a $1000 loss.Subtracting the initial credit of $200 taken, the resulting loss is $800.

Note: While we have covered the use of this strategy with reference to stock options, the

covered put is equally applicable using ETF options,index optionsas well asoptions on

futures.

Commissions
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However, for active traders, commissions can eat up a sizable portion of their profits in the

long run. If you trade options actively, it is wise to look for a low commissions broker.Traders who trade large number of contracts in each trade should check outOptionsHouse.comas they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Naked Call Writing

An alternative but similar strategy to writing covered puts is towrite naked calls.Naked callwriting has the same profit potential as the covered put write but is executed using calloptions instead.

In-The-Money Naked Call0.00% Commissions Option Trading!


The in-the-money naked call strategy involves writingdeep-in-the-moneycall optionswithout owning the underlying stock.It is an alternative to shorting the stock employed whenone is bearish to very bearish on the underlying.

Naked Call (ITM) ConstructionSell 1 ITM Call

Limited Profit Potential

The main objective of writing deep-in-the-money naked calls is to collect thepremiumswhenthe call options drop in value or expire worthless as the underlying stock price declines. Profitis limited to the premium collected for writing the call options.


Max Profit = Premium Received - Commissions Paid Max Profit Achieved When Price of Underlying


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Naked Call (ITM) Payoff Diagram



Unlimited Loss Potential

If the stock price goes up dramatically at expiration, the call writer will be required to satisfythe options requirements to sell the obligated stock to the options holder at the lower strike

price by buying the stock from the open market at higher market price. Since there is no limit

to how high the stock price can be at expiration, potential losses for writing in-the-moneynaked calls is therefore theoretically unlimited.


Maximum Loss = Unlimited Loss Occurs When Price of Underlying > Strike Price of Short Call + Net Premium

Received Loss = Price of Underlying - Strike Price of Short Call - Max Profit + Commissions

Paid

Breakeven Point(s)

The underlier price at which break-even is achieved for the naked call (itm) position can becalculated using the following formula.

Breakeven Point = Strike Price of Short Call + Premium Received

Example

The stock XYZ is currently trading at $48. An options trader decides to writes a JUL 40 in-

the-money call for $10. So he receives $1000 for writing the call option.


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On expiration date, the stock had rallied to $68. Since the striking price of $40 for the calloption is lower than the current trading price, the call is assigned and the writer buys theshares for $6800 and sell it to the options holder at $4000, resulting in a loss of $2800.However, since he received $1000 earlier on, his net loss comes to $1800.

If the stock price drops moderately to $45, the cal writer can realise a profit from the loss inpremium value of the call option sold. Since the striking price of $40 for the call option islower than the current trading price, the call is assigned and the writer buys the shares for$4500 and sell it to the options holder at $4000, resulting in a loss of $500. However, as hehad received $1000 for the sale of the call earlier, his profit for the trade is $500.

However, what happens should the stock price had gone down 20 points to $28 instead? Let'stake a look.

At $28, the call expires worthless and the writer of the naked call keeps the full $1000 inpremiums received as profit.

From the profit graph shown earlier, we can see that the breakeven is at $50 (Call Strike +Premium). So long as the stock price remains at $50 or below, the naked call writer will notsuffer any loss.


naked call (itm) is equally applicable using ETF options,index optionsas well asoptions on

futures.

Commissions



Similar StrategiesThe following strategies are similar to the naked call (itm) in that they are also bearishstrategies that have limited profit potential and unlimited risk.

Out-Of-The-Money Naked Call Covered Put
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Long Put



The long put option strategy is a basic strategy in options trading where the investor buyputoptionswith the belief that the price of theunderlying securitywill go significantly below thestriking price before theexpiration date.

Long Put Construction

Buy 1 ATM Put

Put Buying vs. Short Selling

Compared to short selling the stock, it is more convenient to bet against a stock bypurchasing put options as the investor does not have to borrow the stock to short.Additionally, the risk is capped to the premium paid for the put options, as opposed tounlimited risk when short selling the underlying stock outright.

However, put options have a limited lifespan. If the underlying stock price does not movebelow the strike price before the option expiration date, the put option will expire worthless.

"Unlimited" Potential

Since stock price in theory can reach zero at expiration date, the maximum profit possiblewhen using the long put strategy is only limited to thestriking priceof the purchased put lessthe price paid for the option.


Maximum Profit = Unlimited Profit Achieved When Price of Underlying = 0 Profit = Strike Price of Long Put - Premium Paid
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Long Put Payoff Diagram



Limited Risk

Risk for implementing the long put strategy is limited to the price paid for the put option nomatter how high the stock price is trading on expiration date.

The formula for calculating maximum loss is given below:

Max Loss = Premium Paid + Commissions Paid

Max Loss Occurs When Price of Underlying >= Strike Price of Long Put

Breakeven Point(s)

The underlier price at which break-even is achieved for the long put position can becalculated using the following formula.

Breakeven Point = Strike Price of Long Put - Premium Paid

Example

Suppose the stock of XYZ company is trading at $40. A put option contract with a strikeprice of $40 expiring in a month's time is being priced at $2. You believe that XYZ stock willfall sharply in the coming weeks and so you paid $200 to purchase a single $40 XYZ putoption covering 100 shares.

Say you were proven right and the price of XYZ stock crashes to $30 at option expirationdate. With underlying stock price now at $30, your put option will now be in-the-money with

anintrinsic valueof $1000 and you can sell it for that much. Since you had paid $200 topurchase the put option, your net profit for the entire trade is therefore $800.
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However, if you were wrong in your assessement and the stock price had instead rallied to$50, your put option will expire worthless and your total loss will be the $200 that you paidto purchase the option.

Note: While we have covered the use of this strategy with reference to stock options, the long

put is equally applicable using ETF options,index optionsas well asoptions on futures.

Commissions


However, for active traders, commissions can eat up a sizable portion of their profits in thelong run. If you trade options actively, it is wise to look for a low commissions broker.

Traders who trade large number of contracts in each trade should check outOptionsHouse.comas they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the long put in that they are also bearish strategies thathave unlimited profit potential and limited risk.

Put Backspread Protective Call

Out-of-the-money Puts

Going long onout-of-the-money putsmaybe cheaper but the put options have higher risk ofexpiring worthless.

In-the-money Puts

In-the-money putsare more expensive than out-of-the-money puts but the amount paid forthetime valueof the option is also lower.

Out-Of-The-Money Naked Call


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The out-of-the-money naked call strategy involves writingout-of-the-money call optionswithout owning theunderlying stock.It is a premium collection options strategy employedwhen one is neutral to mildly bearish on the underlying.

Naked Call (OTM) Construction

Sell 1 OTM Call

The main objective of writing naked calls is to collect the premiums when the options expireworthless. One would write an out-of-the-money naked call every month and if the stock

price stays flat or drops, one would pocket the premiums and repeat the process as long as theperceived market condition remains unchanged.

Naked Call (OTM) Payoff Diagram



Limited Profit Protential

Maximum gain is limited and is equal to thepremiumcollected for selling the call options.


Max Profit = Premium Received - Commissions Paid

Max Profit Achieved When Price of Underlying


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Maximum Loss = Unlimited Loss Occurs When Price of Underlying > Strike Price of Short Call + Premium

Received

Loss = Price of Underlying - Strike Price of Short Call - Premium Received +Commissions Paid

Breakeven Point(s)

The underlier price at which break-even is achieved for the naked call (otm) position can becalculated using the following formula.

Breakeven Point = Strike Price of Short Call + Premium Received

Example

The stock XYZ is currently trading at $48. An options trader decides to writes a JUL 50 out-of-the-money naked call for $3. So he receives $300 for writing the call option.

On expiration date, the stock had rallied to $68. Since the striking price of $50 for the calloption is lower than the current trading price, the call is assigned and the writer buys theshares for $6800 and sell it to the options holder at $5000, resulting in a loss of $1800.However, since he received $300 earlier on, his net loss is $1500.

However, what happens should the stock price had gone down 20 points to $28 instead? Let'stake a look.

At $28, the call expires worthless and the writer of the naked call keeps the $300 in premiumsreceived as profit.

From the profit graph above, we can see that the breakeven is at $53 (Call Strike + Premium).So long as the stock price remains at $53 or below, the naked call writer will not suffer anyloss.

In-the-money Naked Call Write

A more bearish version of this strategy with a higher potential profit is towrite deep-in-the-money naked calls.


naked call (otm) is equally applicable using ETF options,index optionsas well asoptions on

futures.

Commissions
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Similar Strategies

The following strategies are similar to the naked call (otm) in that they are also bearishstrategies that have limited profit potential and unlimited risk.

In-The-Money Naked Call Covered Put

Protective Call



The protective call is a hedging strategy whereby the trader, who has an existing shortposition in the underlying security, buyscall optionsto guard against a rise in the price of thatsecurity.

Protective Call Construction

Short 100 Shares

Buy 1 ATM Call

A protective call strategy is usually employed when the trader is still bearish on theunderlying but wary of uncertainties in the near term. The call option is thus purchased to

protect unrealized gains on the existing short position in the underlying.

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The protective call is also known as asynthetic long putas its risk/reward profile is the samethat of along put's.Like the long put strategy, there is no limit to the maximum profitattainable using this strategy.



Profit Achieved When Price of Underlying < Sale Price of Underlying - Premium Paid

Profit = Sale Price of Underlying - Price of Underlying - Premium Paid

Protective Call Payoff Diagram



Limited Risk

Maximum loss for this strategy is limited and is equal to the premium paid for buying the calloption.


Max Loss = Premium Paid + Call Strike Price - Sale Price of Underlying + Commissions Paid

Max Loss Occurs When Price of Underlying


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Example

An options trader is short 100 shares of XYZ stock trading at $50 in June. He implements aprotective call strategy by purchasing a SEP 50 call option trading at $200 to insure his shortposition against a devastating move to the upside.

Max Loss Capped at $200

Maximum loss occurs when the stock price is $50 or higher at expiration. Even if the stockrallies to $70 on expiration, his max loss is capped at $200. Let's see how this works out.

At $70, his short stock position will suffer a loss of $2000. However, his SEP 50 call willhave an intrinsic value of $2000 and can be sold for that amount. Including the initial $200

paid to buy the call option, his net loss will be $2000 - $2000 + $200 = $200.


There is no limit to the profits attainable should the stock price head south. Suppose the stockprice crashes to $30, his short position will gain $2000. Excluding the $200 paid for theprotective call, his net profit is $1800.


protective call is equally applicable using ETF options,index optionsas well asoptions on

futures.

CommissionsFor ease of understanding, the calculations depicted in the above examples did not take intoaccount commission charges as they are relatively small amounts (typically around $10 to$20) and varies acrossoption brokerages.


Similar Strategies

The following strategies are similar to the protective call in that they are also bearishstrategies that have unlimited profit potential and limited risk.
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Put Backspread



The put backspread (reverse put ratio spread) is a bearish strategy in options trading thatinvolves selling a number ofput optionsand buying more put options of the sameunderlyingstockandexpiration dateat a lowerstrike price.It is an unlimited profit, limited risk options
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trading strategy that is taken when the options trader thinks that the underlying stock willexperience significant downside movement in the near term.

Put Backspread Construction

Sell 1 ITM Put

Buy 2 OTM Puts

A 2:1 put backspread can be implemented by buying a number of puts at a higher strike andbuying twice the number of puts at a lower strike.

Put Backspread Payoff Diagram




This strategy profits when the stock price makes a strong move to the downside beyond thelower breakeven point.There is no limit to the maximum possible profit for the put

backspread.



Profit Achieved When Price of Underlying < 2 x Strike Price of Long Put - StrikePrice of Short Put + Net Premium Received

Profit = Strike Price of Long Put - Price of Underlying - Max Loss

Limited Risk

Maximum loss for the put backspread is limited and is incurred when the underlying stock

price at expiration is at the strike price of the long puts purchased. At this price, both the longputs expire worthless while the short put expires in the money. Maximum loss is equal to the
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intrinsic valueof the short put plus or minus any debit or credit taken when putting on thespread.


Max Loss = Strike Price of Short Put - Strike Price of Long Put - Net PremiumReceived + Commissions Paid

Max Loss Occurs When Price of Underlying = Strike Price of Long Put

Breakeven Point(s)

There are 2 break-even points for the put backspread position. The breakeven points can becalculated using the following formulae.

Upper Breakeven Point = Strike Price of Short Put

Lower Breakeven Point = Strike Price of Long Put - Points of Maximum Loss

Example

Suppose XYZ stock is trading at $48 in June. An options trader executes a 2:1 put backspreadby selling a JUL 50 put for $400 and buying two JUL 45 puts for $200 each. The netdebit/credit taken to enter the trade is zero.

On expiration in July, if XYZ stock is trading at $45, both the JUL 45 puts expire worthlesswhile the short JUL 50 put expires in the money with $500 in intrinsic value. Buying backthis put to close the position will result in the maximum loss of $500 for the options trader.

If XYZ stock drops to $40 on expiration in July, all the options will expire in the money. Theshort JUL 50 put is worth $1000 and needs to be bought back to close the position. Since thetwo JUL 45 puts bought is now worth $500 each, their combined value of $1000 is justenough to offset the losses from the written put. Therefore, he achieves breakeven at $40.

Below $40 though, there will be no limit to the gains possible. For example, at $30, each longJUL 45 put will be worth $1500 while his single short JUL 50 put is only worth $2000,resulting in a profit of $1000.

If the stock price had rallied to $50 or higher at expiration, all the options involved willexpire worthless. Since the net debit to put on this trade is zero, there is no resulting loss.

Note: While we have covered the use of this strategy with reference to stock options, the put

backspread is equally applicable using ETF options,index optionsas well asoptions on

futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into

account commission charges as they are relatively small amounts (typically around $10 to$20) and varies acrossoption brokerages.
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Similar Strategies

The following strategies are similar to the put backspread in that they are also bearishstrategies that have unlimited profit potential and limited risk.

Protective Call Long Put

Ratio Spread

The converse strategy to the backspread is the ratio spread.Ratio spreadsare used when littlemovement is expected of the underlying stock price.

Call Backspread

The backspread can also be constructed using calls. Unlike the put backspread, thecallbackspreadis a bullish strategy.

Selling Index Calls



The index short call strategy is a bearish strategy designed to earn from the premiums forselling the index call options with the hope that they expire worthless.

Index Short Call Construction

Sell 1 ATM Index Call

The options trader employing the index short call strategy expects the underlying index levelto be below the call strike price on option expiration date.


Maximum profit is limited to the premiums received for selling the index calls.
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Max Profit = Premium Received - Commissions Paid Max Profit Achieved When Index Settlement Value Index Call Strike Price + Premium

Received Loss = Index Settlement Value - Index Call Strike Price - Premium Received +

Commissions Paid

Breakeven Point(s)

The underlier price at which break-even is achieved for the index short call position can becalculated using the following formula.

Breakeven Point = Index Call Strike Price + Premium Received

Example


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XYZ Index is a broad based index representative of the entire stock market and its value inJune is 400. Believing that the broader market will fall moderately in the near future, anoptions trader sells a six-month XYZ index call with a strike price of $400 expiring inDecember for a quoted price of $4.50 per contract. With a contract multiplier of $100, the

premiums received for selling the index call option comes to $450.

Suppose XYZ Index rose to 420 in December and the DEC 400 XYZ index call expires in-the-money. At settlement value of 420, the DEC 400 XYZ index call option will possess anintrinsic value of $20 and upon assignment of this option, the trader is required to pay asettlement amount of $2000 ($20 x $100 contract multiplier). Taking into account the

premium received for selling the index call option, which is $450, the trader's net loss comesto $1550.

Suppose XYZ Index went down to 380 in December and the DEC 400 XYZ index callexpires out-of-the-money. At settlement value of 380, the DEC 400 XYZ index call optionwill expire worthless with zero intrinsic value. The trader's net profit is therefore equal to the

amount received for selling the index call option which is $450.

Commissions


However, for active traders, commissions can eat up a sizable portion of their profits in thelong run. If you trade options actively, it is wise to look for a low commissions broker.

Traders who trade large number of contracts in each trade should check outOptionsHouse.comas they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Synthetic Long Put



A synthetic long put is created when short stock position is combined with along callof the

same series.

The synthetic long put is so named because the established position has the same profitpotential aslong put.

Synthetic Long Put Construction

Short 100 SharesBuy 1 ATM Call


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Maximum Profit = Unlimited Profit Achieved When Price of Underlying < Sale Price of Underlying - Premium

Paid Profit = Sale Price of Underlying - Price of Underlying - Premium Paid

Synthetic Long Put Payoff Diagram



Limited RiskThe formula for calculating maximum loss is given below:

Max Loss = Premium Paid + Commissions Paid

Max Loss Occurs When Price of Underlying = Strike Price of Long Call

Breakeven Point(s)

The underlier price at which break-even is achieved for the synthetic long put position can becalculated using the following formula.

Breakeven Point = Sale Price of Underlying - Premium Paid

Synthetic Short Call



A synthetic short call is created when short stock position is combined with a short put of thesame series.
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Synthetic Short Call Construction

Short 100 SharesSell 1 ATM Put

The synthetic short call is so named because the established position has the same profit

potential a short call.



Max Profit = Premium Received - Commissions Paid Max Profit Achieved When Price of Underlying Sale Price of Underlying + Premium

Received Loss = Price of Underlying - Sale Price of Underlyingl - Premium Received +

Commissions Paid

Breakeven Point(s)

The underlier price at which break-even is achieved for the synthetic short call position canbe calculated using the following formula.


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Maximum Profit = Unlimited Profit Achieved When Price of Underlying < Strike Price of Long Put + Net Premium

Received

Profit = Strike Price of Long Put - Price of Underlying + Net Premium Received

Unlimited Risk

Like the short stock position, heavy losses can occur for the synthetic short stock if theunderlying stock price shoots upwards.


Maximum Loss = Unlimited

Loss Occurs When Price of Underlying > Strike Price of Short Call + Net PremiumReceived

Loss = Price of Underlying - Strike Price of Short Call - Net Premium Received +Commissions Paid

Breakeven Point(s)

The underlier price at which break-even is achieved for the synthetic short stock position canbe calculated using the following formula.

Breakeven Point = Strike Price of Long Put + Net Premium Received

Example

Suppose XYZ stock is trading at $40 in June. An options trader setups a synthetic short stockby buying a JUL 40 put for $100 and selling a JUL 40 call for $150. The net credit taken toenter the trade is $50.

If XYZ stock rallies and is trading at $50 on expiration in July, the long JUL 40 put willexpire worthless but the short JUL 40 call expires in the money and has an intrinsic valueof$1000. Buying back this short call will require $1000 and subtracting the initial $50 credit

taken when entering the trade, the trader's loss comes to $950. Comparatively, this is veryclose to the loss of $1000 for a short stock position.

On expiration in July, if XYZ stock is instead trading at $30, the short JUL 40 call will expireworthless while the long JUL 40 put will expire in the money and be worth $1000. Includingthe initial $50 credit taken, the trader's profit comes to $1050. This amount closelyapproximates the $1000 gain of the corresponding short stock position.

Commissions
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Advantages vs Short Stock

Three important reasons make the synthetic short stock strategy superior to actual shortselling of the underlying stock. Firstly, there is no need to borrow stock to short sell.Secondly, there is no need to wait for the uptick, thus transactions are more timely. Finally,there is no need to pay dividends on the short stock (if the underlying security is a dividend

paying stock).

Synthetic Short Stock (Split Strikes)

There is a more aggressive version of this strategy where both the call and put optionsinvolved areout-of-the-money.While a larger downside movement of the underlying stock

price is required to make large profits, thissplit strikes strategydoes provide more room forerror.

Synthetic Long Stock

The converse strategy to the synthetic short stock is thesynthetic long stock,which is usedwhen the options trader is bullish on the underlying but seeks an alternative to purchasing thestock itself.

Synthetic Short Stock (Split Strikes)



The synthetic short stock (split strikes) is a less aggressive version of thesynthetic short stockstrategy.

The synthetic short stock (split strikes) position is created by selling slightlyout-of-the-money callsand buying an equal number of slightlyout-of-the-money putsof the sameunderlying stockandexpiration date.

Synthetic Short Stock (Split Strikes) Construction

Sell 1 OTM Call
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Buy 1 OTM Put

The split strike version of the synthetic short stock strategy offers some upside protection. Ifthe trader's outlook is wrong and the underlying stock price rises slightly, he will not suffer

any loss. On the flip side, a stronger downward move is necessary to produce a profit.

Profits and losses with a split strike strategy are also not as heavy as a corresponding shortstock position as the strategist has traded some potential profits for upside protection.

Synthetic Short Stock (Split Strikes) Payoff Diagram




Similar to a short stock position, there is no limit to the maximum possible profit for thesynthetic short stock (split strikes). The options trader stands to profit as long as the

underlying stock price goes down.



Profit Achieved When Price of Underlying < Strike Price of Short Call + Net Premium

Received OR Price of Underlying < Strike Price of Long Put - Net Premium Paid

Profit = Strike Price of Long Put - Price of Underlying +/- Net Premium Received/Paid

Unlimited Risk

Like the short stock position, heavy losses can occur for the synthetic short stock (splitstrikes) if the underlying stock price makes a sharp move upwards.
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Often, a credit is usually taken when establishing this position. Hence, even if the underlyingstock price remains unchanged on expiration date, there will still be a profit equal to theinitial credt taken.


Maximum Loss = Unlimited

Loss Occurs When Price of Underlying > Strike Price of Short Call + Net Premium Received OR

Price of Underlying > Strike Price of Long Put - Net Premium Paid

Loss = Price of Underlying - Strike Price of Short Call +/- Net Premium Paid/Received +

Commissions Paid

Breakeven Point(s)

The underlier price at which break-even is achieved for the synthetic short stock (split strikes)

position can be calculated using the following formula.

Breakeven Point = Strike Price of Short Call + Net Premium Received OR Strike Price of Long

Put - Net Premium Paid

Example

Suppose XYZ stock is trading at $40 in June. An options trader setups a split-strikes syntheticshort stock by buying a JUL 35 put for $50 and selling a JUL 45 call for $100. The net credittaken to enter the trade is $50.

Scenario #1: XYZ stock price falls slightly to $35

If the price of XYZ stock drops to $35 on expiration date, both the long JUL 35 put and theshort JUL 45 call will expire worthless and the trader keeps the initial credit of $50 as profit.

Scenario #2: XYZ stock rallies explosive to $60

If XYZ stock rallies and is trading at $60 on expiration in July, the long JUL 35 put willexpire worthless but the short JUL 45 call expires in the money and has an intrinsic value of$1500. Buying back this short call will require $1500 and subtracting the initial $50 credit

taken when entering the trade, the trader's loss comes to $1450. A heavier loss of $2000 losswould have been suffered by a corresponding short stock position.

Scenario #3: XYZ stock price falls to $20

On expiration in July, if the price of XYZ stock has instead crashed to $20, the short JUL 45call will expire worthless while the long JUL 35 put will expire in the money and be worth$1500. Including the initial credit of $50, the options trader's profit comes to $1550.Comparatively, a corresponding short stock position would have achieved a greater profit of$2000.

Commissions


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Synthetic Short Stock

There is amore aggressive versionof this strategy where both the call and put optionsinvolved areat-the-money.While a smaller downside movement of the underlying stock

price is required to accrue large profits, this alternative strategy provides less room for error.
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Option Strategies When Market is BEARISH

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