Bull Split-Strike Combo

A top trader once told me, “don’t take risks with your money, take risks with other peoples money.” Such an attitude made many folks on Wall Street rich, and helped fuel a global financial crisis. With ethics, one always wins in the end. To make things clear, when trading short-term, or investing long-term, there’s always risk involved. If anyone advises otherwise, they either lack competence or they’re lying. When trading or advising others, I often use directional strategies that can be reversed if they’re not working.

One of my favorite bullish strategies is a Bull Split-Strike Combo. I employ this strategy when I’m:

  1. Bullish on an underlying security
  2. Generally bullish on the broad market
  3. Want to buy a security at a specific price

With this strategy, I am partially financing the purchase of Call Options, by selling Put Options. This strategy is similar to a synthetic long position, the difference being that the strike price of my call and put option positions differ. A synthetic position is created by combining assets to artificially create a desired position. For instance, a synthetic long stock position can be created by buying call options and selling put options on the same underlying stock, using the same number of contracts, the same expiration date, and the same strike price.

In a Bull Split-Strike Combo, one buys Call Options, and Sells Put Options with a lower strike price on the same underlying stock, with same number of contracts, and same expiration date.

Bull Split-Strike Combo Example:

Buy 1 December 2009 $16 Call Option on BAC

Sell 1 December 2009 $15 Put Option on BAC

Risk  can be substantial, i.e. the put option could be exercised, requiring you to purchase 100 share of BAC at $15; the price of BAC could theoretically go to zero. Total risk equals net debit paid + (strike price x 100) if done for a debit  (the most likely scenario), or (strike price x 100) – credit received, if done for a credit.

Reward: Unlimited

Increase in Volatility: Typically helps position

Time Erosion: Typically hurts position

Break Even Point:

  1. If established for a debit (most likely scenario): Long call strike plus net premium paid
  2. If established at a credit, short put strike minus net premium received

What if the value of BAC goes down, for instance below the strike price of the put option?  In this case, if I can buy-to-close my put position prior to being exercised against me, I can mitigate potential deeper losses.  Likewise, I can sell-to-close my long call position to re-capture any remaining premium value. To reiterate, I only invoke this strategy if I’m interested in purchasing a security at a specific price. Since in this example, I sold a BAC put option, this means I am required to buy 100 shares of BAC at $15/share if exercised against me. Therefore, I must be comfortable with the fact that I might have to buy BAC at $15.

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3 Comments

Filed under Finance

3 responses to “Bull Split-Strike Combo

  1. Fred Phillips

    Great advice on trading strategy Thanks

    Fred Phillips

  2. Greg Collier

    Reblogged this on Greg Collier's Blog.

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