Personal Finance & Money Asked by John Shedletsky on February 12, 2021
Often different stocks that I want to short are not on my broker’s “easy-to-borrow” list, so they are unavailable for shorting.
A couple weeks ago I got serious about option trading and I found out about the “short combo”. This is when you write a call and buy a put at the same strike price. The net result is a payoff very similar to being short the underlying stock.
Depending on the strike price that you choose, it’s possible to enter this position at a net credit (due to the premium for writing the call being greater than the cost of the put).
The thing I can’t get my head around is why this should be so.
For instance, right now I can enter a short combo against Barnes and Noble (BKS) for a credit of 1145 USD if I choose the strike price of 10. However, the credit is only 240 USD if I use the strike of 20. The underlying traded at 21.54 at today’s close.
Since the payoffs are the same, why do I get a larger credit with the further ITM strike? I’ve looked at it in some option graphing software, and I suspect that the answer has something to do with the relatively higher extrinsic value of the combo at the 10 strike.
A more intuitive explanation would be appreciated!
If I am trying to create a synthetic short against a hard-to-borrow stock, I assume I should use the strike closest to the underlying price. Is this the case? If not, how do you select the right strike given this goal?
You have that backwards. The $10 combo is trading near intrinsic value and it's the $20 combo that has the higher extrinsic value (- 9 cents versus + 86 cents).
You have to look at your contractual obligation in order to understand why the total credit for the $10 combo is larger than that of the $20 combo (not extrinsic credit).
With the $10 short call, your call obligates you to sell the stock at $10 or $11.54 less than the current price. Why would you agree to sell the stock for anything less than current price of $21.54 ? You must receive at least $11.54 to take this position. Since the credit for the $10 synthetic short combo is $11.45, you are effectively paying 9 cents for this combo.
With the $20 short call, your call obligates you to sell the stock at $20 or $1.54 less than the current price. Why would you agree to sell the stock for anything less than current value of $21.54 ? You must receive at least $1.54 to take this position. Since the credit for the $20 synthetic short combo is $2.40, you are receiving an 86 cents credit for this combo.
A way to verify the equivalence of these two positions with option graphing software is to buy one of these combos and sell the other. If you do, you'll see that the risk graph is a horizontal line with a P&L of + or - 95 cents, depending on which combo you sell.
Selling a deep ITM synthetic is problematic because there's a higher probability that you will be assigned early, even more so if the stock pays a dividend.
Another FWIW is that dividends as well as increased carry cost may alter the P&L of the combo.
Answered by Bob Baerker on February 12, 2021
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