Shorting stock is a high-risk strategy that most traders avoid. It requires borrowing stock from your brokerage firm, selling it, and hoping the price falls. You have to maintain margin and pay interest on the borrowed stock; and if the stock price rises, margin requirements grow and you could end up losing. You can duplicate the potential profits without all of that risk by creating a synthetic short sale with options.
A “synthetic” short sale is a combined option strategy that acts just like short stock. It consists of a short call and a long put opened at the same time, using the same strike and expiration. The strategy has some risks, especially for the short call. However, if you also own 100 shares of the underlying stock, the synthetic short sale includes a covered call and a long put, drastically reducing the risk and adding downside protection for the 100 shares of stock.
The two major advantages to the synthetic position are: (1) you do not need to borrow stock; and (2) the cost is very low, with the short and long offsetting one another. The synthetic short can be used for two purposes. First, it provides an alternative to the riskier, more expensive short stock position, and margin requirements are going to be lower as well. Second, if you own 100 shares of stock, the synthetic short is a better choice than buying an insurance put.
Here is an example of how it works. A particular stock is currently valued at $40 per share. The August 40 call is worth 6 and the August 40 put is worth 5. If you sell the call and buy the put, you create a net credit of 1 ($100), less trading costs. If the stock price moves down, the call remains out of the money and loses time value; and the put gains point for point with the stock in intrinsic value. If the stock price rises, the put loses value as it is out of the money, and the short call loses money in point-for-point matching of intrinsic value (less time decay). However, if the call is covered by 100 shares of stock, the synthetic position loss is offset by equivalent gains in the long stock.
In the situation combining a covered short call with a long put, the synthetic short stock strategy does not lose, whether stock prices rise or fall. It is a better approach than shorting stock and buying an insurance put.
Michael C. Thomsett is an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks.