The setup
- Sell a call, strike price A
- Buy a put, strike price A
- The stock should be at or very near strike A
The strategy
Buying the put gives you the right to sell the stock at strike price A. Selling the call obligates you to sell the stock at strike price A if the option is assigned.
This strategy is often referred to as “synthetic short stock” because the risk / reward profile is nearly identical to short stock.
If you remain in this position until expiration, you are probably going to wind up selling the stock one way or the other. If the stock price is above strike A, the call will be assigned, resulting in a short sale of the stock. If the stock is below strike A, it would make sense to exercise your put and sell the stock. However, most investors who run this strategy don’t plan to stay in their position until expiration.
At initiation of the strategy, you will most likely receive a net credit, but you will have some additional margin requirements in your account because of the short call. However, those costs will be fairly small relative to the margin requirement for short stock. That’s the reason some investors run this strategy: to avoid having too much cash tied up in margin created by a short stock position.
Options guys tips
It’s important to note that the stock price will rarely be precisely at strike price A when you establish this strategy. If the stock price is above strike A, you’ll receive more for the short call than you pay for the long put. So the strategy will be established for a net credit. If the stock price is below strike A, you will usually pay more for the long put than you receive for the short call. So the strategy will be established for a net debit. Remember: The net credit received or net debit paid to establish this strategy will be affected by where the stock price is relative to the strike price.
Dividends and carry costs can also play a large role in this strategy. For instance, if a company that has never paid a dividend before suddenly announces it’s going to start paying one, it will affect call and put prices almost immediately. That’s because the stock price will be expected to drop by the amount of the dividend after the ex-dividend date. As a result, put prices will increase and call prices will decrease independently of stock price movement in anticipation of the dividend. If the cost of puts exceeds the price of calls, then you will have to establish this strategy for a net debit. The moral of this story is: Dividends will affect whether or not you will be able to establish this strategy for a net credit instead of a net debit. So keep an eye out for them if you’re considering this strategy.
On the other hand, you may want to consider running this strategy on stock you want to short but that has a pending dividend. If you are short stock, you will be required to pay any dividends out of your own account. But with this strategy, you’ll have no such requirement.
