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>> PODCAST: tastylive's Jermal Chandler makes sense of the stock market<<

Synthetic Short
Outlook: Bearish

As the name indicates, the synthetic short spread replicates the risk/reward dynamic of a short stock position. By combining a long put and a short call at the same strike, the position offers gains on a bearish move, while a bullish move can translate quickly into steep losses. So, if you'd like to sell a stock short without borrowing shares from your broker, the synthetic short might be a worthwhile strategy.

To understand how the synthetic short works, let's look at an example.

Entering the Trade

With Stock XYZ at $64, you expect the shares to tank over the near term. To build a synthetic short spread, you buy to open a 65-strike put at the ask price of 2.00, and simultaneously sell to open a 65-strike call at the bid price of 0.99. After subtracting your 0.99 credit from the 2.00 expenditure, the initial net debit on the spread is 1.01, or -- multiplied by 100 shares per contract -- $101.

It's worth noting here that strike selection plays a key role in whether this trade is initiated for a net debit or a net credit. Depending upon where the stock is trading in relation to the strike price, the call may occasionally be more expensive than the put, resulting in an initial net credit. However, since the synthetic short is inherently a bearish trade, it makes sense to back up that belief by choosing a strike where the put is worth more than the call.

Potential Gains

From here, the best-case scenario is for XYZ to plummet all the way to zero by expiration. This will reap the maximum profit on the put, while the short call can be left to expire worthless.

If the trade is opened for a net debit, your maximum gain is equal to the purchased put strike less your net debit -- in this case, 65 - 1.01 = 63.99, or $6,399 after accounting for 100 shares per contract. If the trade is opened for a net credit, your maximum gain is equal to the purchased put strike plus the net credit.

Of course, you can still win if the stock drops, even if it doesn't tank all the way to zero. If the trade was opened for a net debit, you'll begin to profit on a move south of breakeven, which is equal to the purchased put strike less the net debit -- or 65 - 1.01 = 63.99. If you entered the trade for a net credit, you're already in the plus column at initiation. Any move by the stock below the strike price of your purchased put will translate into additional profits, equal to the difference between the strike price and the stock price.

Potential Losses

Since you're short a call option, the maximum risk on this trade is theoretically unlimited -- making a rally above the call strike your worst-case scenario.

If you entered the trade for a net debit, you need XYZ to settle at or below breakeven (put strike less net debit, or $63.99) to avoid taking a loss.

If the trade was initiated for a net credit, you'll begin to lose money once the stock rises above a different breakeven level, which is equal to the call strike plus the net credit. Once the shares rise above this level, you'll have forfeited your entire net credit and will begin to rack up losses on the call.

Volatility Impact

Since you've got a long put and a short call at the same strike, you're relatively buffered from implied volatility fluctuations at the outset of the trade. However, if the stock begins falling, you'd prefer to see volatility rise; if the stock rallies, you'd prefer to see volatility fall.

Other Considerations

There are a few pros and cons to consider before playing a synthetic short. On the pro side: 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.

The unlimited risk involved in a synthetic short is a pretty serious con, though. On its own, a long put offers limited risk and carries no margin requirement -- two major advantages of buying puts over short selling. By partnering a long put with a short call, you've essentially forfeited both of these advantages.

In terms of trade structure, it's worth noting that you can modify the synthetic short by playing your call and put at different strikes -- for example, buying an in-the-money put and selling an out-of-the-money call. This variant is known as a "split-strike synthetic short."

Synthetic Short


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