Synthetic Short Stock
If synthetic stock is just a long call plus a short put what would synthetic short stock be? Once again, all we have to do is change the signs of our previous answer and find out that a long put plus a short call will behave just like a short stock position. This is great to know for all traders involved in short selling. With synthetic options, it is now possible to short stock without an uptick or when stock is not even available for shorting.
 
Question
You wish to short a stock, which is trading for $100. Your broker informs you that the stock is not marginable and therefore cannot be shorted. How can you effectively enter a short sale?
 
Answer
Enter a synthetic short by selling the $100 call and buying the $100 put.
 
How much will it cost to enter an at-the-money synthetic short stock trade? Think back to put-call parity. One variation was:
 
C – P = S – Present value E
 
This tells us that if we buy the call and sell the put (left side) it should be worth the difference between the stock price and present value of the exercise price (right side). Because we are doing the reverse and buying the put and selling the call, the transaction should result in a slight credit.
 
Realistically though, because of bid-ask spreads and commissions, the trade may result in a slight debit. Regardless, it will not be a major cash outlay to enter this position (please keep in mind that there will be significant margin requirements to do so). However, they should not exceed (and will usually be much less) than the 150% Reg T margin required to short a stock. So not only can synthetics allow trades that otherwise cannot be done, they usually allow it to be done in a more efficient way by requiring less capital to take the same position.
 
Example: Figure 5-16 shows a chart of the S&P 100 (OEX). Between May 17 and June 3, 2002 (the area to the right of the dotted vertical line), the OEX took another. While there is usually no way to short the OEX index through the stock market, you could have done it synthetically in the options market.
Figure 5-16
 

Figure 5-16

On May 17, the index was trading at 550 and the 550 calls were $13.00 with the 550 puts at $11.80. As we showed earlier, an at-the-money synthetic short will usually result in a slight credit, which was the case here. Selling 20 calls and buying 20 puts would result in a net credit of 20 contracts * 100 * $1.20 credit = $2,400. Just 17 days later, at the close of the trading, the puts were worth $38.20 and the calls 0.80. The synthetic short position could have been closed out for a credit of $37.40 * 20 * 100 = $74,800. For no money down (in fact, a credit of $2,400) you could capture a $70,000 profit in a relatively short time. Of course, this trade does not come without risk. The risk is that the index traded higher, which would have left you with an equally big loss if the index had risen by the same amount. We’re just trying to show that synthetics allow you to initiate positions that others will tell you cannot be done. The more agile and efficient you are at establishing positions, the better trader and investor you will become. Synthetics give you those abilities.
 
 
Added Insights into Synthetics
            All combinations of synthetics can be created by Formula 5-15 which is:
 
S + P – C = 0
 
            Now that you understand synthetics, it is easier to see why the formula works. Assume you are long stock and also have another asset in your portfolio. You don’t know what this asset is but you are told that it makes your long stock position risk free. What does that tell you about the other asset? If you have no risk, then the other assets must be short stock. If you are long stock and short stock, then you are effectively flat and have no risk. Now think about our synthetic formula. If you are long stock and have other assets (shown by the box) and are also told that you have no risk then the boxed assets (long put + short call) must be equal to short stock and that’s exactly what we found out.
 


S   + P – C    = 0
 
            To find any synthetic equivalent, all you need to do is isolate the variable(s) you’re trying to solve for and the answer will be immediately visible. Let’s try another. If you want to find out the synthetic equivalent to a long put, just isolate that +P position:
 


S   + P   – C    = 0
 
            If that long put is paired with other assets so that it has no risk, then the other assets must be equal to a short put. This immediately shows that long stock plus a short call must be equal to a short put.
 
            It turns out that no matter which asset you pick, the other two are the synthetic opposite and fully hedge the risk. It should make sense, then, that we could also pick any two assets and know that the third will fully hedge those two.
 
 
All Combinations of Synthetics
            It is great practice to run through Formula 5-15 and figure out the various combinations of synthetic trades. If you are really motivated, try to draw the corresponding profit and loss diagrams. All of the combinations are listed below for your reference. Note that the short positions are exactly the opposite of the long positions.
 
Asset
Synthetic Equivalent
Long stock
Long call + Short put
Short stock
Short call + Long put
Long call
Long stock + Long put
Short call
Short stock + Short put
Long put
Short stock + Long call
Short put
Long stock + Short call
 
            Synthetic trades may seem complex at first but, in reality, are actually quite simple. Many think they are a needless academic exercise and of no practical use but nothing could be further from the truth. If you plan to actively trade options, it is crucial to understand synthetics. Market makers make their living with the put-call parity relationship so don’t think it’s a waste of your time to gain a basic understanding. A little time invested will make option investing worth your time.
 
All combinations of synthetic positions are derived from the put-call parity equation.  
 
Real Applications for Synthetics
            Are synthetics really useful? In Chapter Four we found that it is never advantageous to exercise a call option early except to collect a dividend. When you exercise a call option, you give up the rights with the call option in exchange for the stock. If you exercise a call to gain the stock, you are holding all of the downside risk of the stock in exchange for collecting the dividend. Now that you understand synthetics, we can perhaps find a better way to do this. When you are long the call, rather than exercising it, you could, instead, sell the same strike put. This creates a synthetic long stock position (since you are long the call and short the put), which is effectively the same position you were going to have if you exercised the call. While the synthetic long stock position does not allow you to collect the dividend, it does let you collect the premium of the put. In many cases, this put premium will be of greater value than the dividend on the stock while either choice exposes you to the same downside risk. In addition, by choosing the synthetic long call position, you can hold onto the exercise value of the cash a little longer to earn interest. In other words, if you choose to exercise the call, you must pay for the stock today.
 
By entering the synthetic long stock position, you will end up buying the stock at the same price but at a later date. Why? For the synthetic long stock position, you are long the call and short the put. If the stock price is above the strike at expiration, you will exercise the call and buy the stock for the exercise price. If the stock’s price is below the strike, you will be assigned on the put and buy the stock for the strike price. No matter where the stock’s price is at expiration, you will pay the strike price and receive the stock, which is exactly what you would have done had you exercised the call only at a later date. This allows you to hold onto the cash for a longer period of time to earn interest. As long as the put premium plus interest earned exceeds the value of the dividend, you are better off with the synthetic long stock position. This means that it may still be advantageous to use the synthetic stock strategy even if the put premium is less than the dividend. You must compare the put premium plus interest earned to the dividend. Only when the dividend exceeds the value of the put plus interest should you exercise the call for the dividend. Please keep in mind that we are not saying that you should always capture either the dividend or put premium. In many cases, neither choice may warrant holding all of the downside risk of the stock whether synthetically or not.We just mean that if you have decided it is worthwhile, then you should consider the synthetic long stock version before exercising the call.
 
The mathematics behind put-call parity work no matter how you may choose to attack a particular problem. For example, we could have solved the problem of early exercise by considering what would happen if you actually exercised the call to get the dividend. If you exercise the call, you are buying stock and effectively selling your call. If you buy stock and sell a call, what have you done synthetically? You have sold a put. Different investors and traders see synthetics in different ways. But no matter how you view them, you’ll arrive at the same answer as long as you are properly applying the put-call parity formula.
 
To be continued…..

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