The synthetic short stock is an options strategy used to simulate the payoff of a short stock position. It is entered by selling at-the-money calls and buying an equal number of at-the-money puts of the same underlying stock and expiration date.
|Synthetic Short Stock Construction|
|Buy 1 ATM Put|
Sell 1 ATM Call
This is an unlimited profit, unlimited risk options trading strategy that is taken when the options trader is bearish on the underlying security but seeks an alternative to short selling the stock.
Similar to a short stock position, there is no maximum profit for the synthetic short stock. The options trader stands to profit as long as the underlying stock price goes down.
Additionally, a credit is usually taken when entering this position since calls are generally more expensive than puts. Hence, even if the underlying stock price remains unchanged on expiration date, there will still be a profit equal to the initial credit taken.
The formula for calculating profit is given below:
Like the short stock position, heavy losses can occur for the synthetic short stock if the underlying stock price shoots upwards.
The formula for calculating loss is given below:
The underlier price at which break-even is achieved for the synthetic short stock position can be calculated using the following formula.
Suppose XYZ stock is trading at $40 in June. An options trader setups a synthetic short stock by buying a JUL 40 put for $100 and selling a JUL 40 call for $150. The net credit taken to enter the trade is $50.
If XYZ stock rallies and is trading at $50 on expiration in July, the long JUL 40 put will expire worthless but the short JUL 40 call expires in the money and has an intrinsic value of $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 very close 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 expire worthless while the long JUL 40 put will expire in the money and be worth $1000. Including the initial $50 credit taken, the trader's profit comes to $1050. This amount closely approximates the $1000 gain of the corresponding short stock position.
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 across option brokerages.
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 out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).
Three important reasons make the synthetic short stock strategy superior to actual short selling 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).
There is a more aggressive version of this strategy where both the call and put options involved are out-of-the-money. While a larger downside movement of the underlying stock price is required to make large profits, this split strikes strategy does provide more room for error.
The converse strategy to the synthetic short stock is the synthetic long stock, which is used when the options trader is bullish on the underlying but seeks an alternative to purchasing the stock itself.
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