Earlier this week, we highlighted the 25 worst stocks in December, looking at data from the last 10 years. While some stocks on that list may be targeted by short sellers looking for history to repeat,there are obvious downsides to selling a stock short. Namely, you have to borrow shares from a broker. However, a synthetic short options strategy allows you to simulate the risk/reward of an actual short stock position, without borrowing the stock. Below, we will break down a synthetic short trade, and compare it to traditional short selling and put buying.
A synthetic short combines a long put and a short call at the same strike price. It is initiated when a trader buys to open a near-the-money put and simultaneously sells to open a call at the same strike. (The trade can be modified by playing your call and put at different strikes in the aptly named split-strike.) Strike selection is important; because since it is an inherently bearish trade, it would be prudent to choose a strike where the put is worth more than the call, resulting in a net debit at initiation.
Should the stock plummet into options expiration, the long put will gain value and the short call will expire worthless. Should the stock rise above the call strike, the call would move into the money, and you will begin to take on losses.
How does this strategy differ from a straight short sale? Let's look at an example. Take two traders, Oscar and Sally. They're both bearish on stock XYZ, which is trading at $98. Oscar initiates a synthetic short by buying to open a February 100 put for $4.70, while simultaneously selling to open a February 100 call for $2.25. Oscar's net debit is $2.25, or $245 (x 100 shares), for the bearish spread.
The breakeven for the trade is $97.55, or the put strike minus the net debit. Oscar's trade will profit the deeper XYZ sinks below $97.55 by the February options expiration date. If XYZ were to head higher, Oscar's losses will increase with the stock's move north of $100, which would then put his sold call into the money.
Comparing this to Sally, who simply sold the stock short, Oscar did not have to borrow XYZ shares. In addition, the margin requirement on the sold call was smaller than Sally's traditional short sale.
Thus, the advantages of a synthetic short plays are: the sale of the call can partially or completely offset the cost of the put; you don't have to borrow shares from your broker; and the margin requirement on the short call is frequently smaller than the margin requirement for a traditional short sale.
However, the synthetic short comes with potentially steep risk.Long puts by themselves offer limited risk and large profit potential, as well as no margin requirement. By linking a long put with a short call in a synthetic short, a trader can lower their cost of entry, but is assuming a lot more risk. "Vanilla" long puts thus represent the simpler, less risky strategy for bears when options are attractively priced.