Synthetic short stock

Description

If the strike price of two options is the same, in a short call / long put combination the postion is equivalent to shorting or short selling. A variation is to use options with different strikes.

When to use


Regardless of which combination ( same or different strikes ) is used the position is either equivalent to short selling or broadly equivalent and hence represents a bearish leveraged trade. 

1. to take advatnage of excess collalteral in an account
2. to minimise trasnaction costs


Short sell for less margin than conventional short selling

Margin requirements on the short call, long put pair depend on the volatilty of the underlying stock but at the time of the trade is typically no more 10% of the value of the exercise price of the options. Check the ASX margin estimator for your particular stock.

In the following example the put call pair generates a net credit of $1.00 per share or $1000.per contract  If we assume margin on the postion is 10% of the exercise value (75K ) the position requires $7.5k less the $1000 credit or $6,500.

Synthetic short stock

Synthetic short stock

Contrast that with short selling the physical stock where the minimum margin that must be maintiatned with a broker is 20%, stock can not be sold on a downtick and typically higher brokerage and its easy to see why synthetically short selling is popular.  


Synthetic short stock - split strikes

Split strike synthetic short stock

 

Risk/Reward Characteristics


Like long stock, the spread's potential is unlimited as are losses because the investor could end up being assigned on the short put. Therefore investors must carefully consider the initial size of the spread.

Break-even Point:

If debit spread: Call strike price + spread debit; If credit spread: Put strike price - spread credit

Time Decay Varies.

If XYZ is near Long Call strike price, time decay is a negative for the spread. If XYX is near Short Put, time decay is a positive.

Volatility.

Neutral. If volatility increases, both options increase in price. Thus, the gain in the Call offsets the loss in the Put. If volatility decreases, the gain in the Put offsets the loss in the Call.

Assignment Risk

The investor must watch XYZ for possible assignment if XYZ declines below the Put's strike.