by Dawn Pennington 08/12/08
Because the long call would be in-the-money, it would allow you to buy stock at the strike price (i.e., below market value) and effectively limit your losses if you are forced to cover your short sale of the stock.
If the position works in your favor, the short sale would become the profitable "leg" of the trade because if the stock goes to $35 and you had bought it at $45, you would "cover" that short by buying shares at $35 and pocketing the $10-per-share profit.
The call would then expire worthless, but for probably a couple dollars' worth of protection, the investment in this "insurance policy" would have been worth it.
As for the synthetic short put strategy, it bears resemblance to a strategy with which you may be familiar -- the covered call. With this type of investment, you buy the stock and short a call against it.
Both strategies aim to take advantage of a flat trading environment by helping you collect a premium from the sale of the calls and effectively make your stock work harder for you.
If you bought a stock during the recent market pullback and it was a terrific bargain, the synthetic short put strategy might be a short-term investment strategy worth considering, as you could short a call at a higher strike price than the market value.
If the value of the stock goes up, that's a profit stream for the investor. If the stock stays relatively neutral, the profit comes from the premium collected from the short sale of the call. But if the stock falls dramatically, the hit that the long stock could take probably can't be offset by the premium collected for the short call.
If the position succeeds (i.e., if the stock continues to trade flat), not only can you profit from the synthetic short-put position you've created, but as the owner of the stock, you're also entitled to any dividends the underlying instrument may pay.
There are many trading strategies that have been designed to help you profit in the options markets, and the more weapons you add to your trading arsenal, the better-prepared you'll be to make memorable returns in any type of market!
If you enjoyed this article, check out Dawn Pennington's "Synthetic Call Options Similar to Real Deal" and "Generate Real Profits Synthetically."
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