The dilemma of the long stock position is unending downside risk. This is where options serve their best purpose: as tools for portfolio management. Rather than use only as speculative and high-risk market plays, strategies like the synthetic short stock position protect against downside loss and, unlike the better-known covered call, offer a practical alternative to selling and taking profits. This position combines a long put and a short call. In a pure synthetic short, no stock would be held at all, making the position higher-risk and requiring deposit of collateral on the short call side.
If you already own stock, the synthetic short stock can add another feature, capping of stock-based market risk along with elimination of the call's risk. Combining a covered call with a long put and creating a synthetic short position avoids having to close stock to take profits or to remain exposed to market risk, as would be the case with a covered call.
Its construction has three parts. For every 100 shares held long, you open a long put and a short call at the same strike. If this is opened at or near the basis in stock, it is a senseless position. If the stock moves up, the call is assigned and your stock called away. If the stock moves down, you exercise your put and sell at the strike. In neither event is there an opportunity for profit.
Now look at the synthetic short stock in another way. Let's assume you bought stock well below current market value and you have two issues in mind. First, you are willing to sell now, but you're not sure if that is a good move. Second, you are tempted to sell because the stock price could easily decline and you would lose part of your paper profits. In this situation, the synthetic short stock makes sense.
For example, you bought 100 shares at $25 per share. Today the stock is worth $29.50. You have an 18% paper profit and you're tempted to sell and take the profit. But the company is paying a 4.5% dividend and you would prefer to keep earning it. If you are willing to sell at $29 to avoid the threat of loss, and you also want to protect against the downside, a synthetic short stock strategy will work for you.
The March 29 call is worth 0.70 and the 29 put is worth 0.42. Selling the call and buying the put creates a net credit of 0.28, but trading costs are likely to offset most of that. At the same time, the paper profit is protected at the 29 strike. If the stock value falls below that, the put's intrinsic value will offset the loss. You can either sell the put to take the profit, or exercise the put and sell shares at $29 per share, this setting up a four-point profit. The put costs nothing because the credit from the short call offsets it. However, in exercising the put and selling stock at a profit, you are left with an uncovered call. That means risk exposure and collateral requirements; so the exercise of the long put should be accompanied by a buy to close of the short call or repurchase of shares at a lower price. This is advantageous because the call's strike will be higher than the stock's market value.
If the stock price rises above 29, the call will be exercised. To avoid exercise you can close the position or roll forward. So you achieve a degree of protection against downside movement while accepting exercise (or avoiding it) on the upside.
As long as you are aware of the various risks and are also willing to post requiring collateral for an uncovered short option, a synthetic short stock can be used in many instances. To find out more about collateral requirements, download the free report from the CBOE at CBOE Margin Manual.
The many possible options strategies make the point that you can use them to speculate, or quite conservatively to manage equity portfolio risks.
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