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A synthetic short stock strategy offers an excellent alternative to a traditional short sale for a fraction of the cost and without the same risk.
Let’s break it down.
The trade is formed by selling a call and buying a put with the same strike price and expiration date, as the example below will show.
But why initiate such a trade if you can just short the stock?
There are several reasons:
- First, a short sale requires you to have sufficient margin in your account before your broker will permit it.
- Tax reporting on a short sale can also be complicated, and depending on whether the trade is considered a short- or long-term hold, your payment to the tax man could be significant.
- Dividends on short stocks have to be paid during the period you are short.
- You may also have to pay interest on the borrowed stock.
- There’s always a chance you’ll be forced to return the borrowed shares to your broker if the owner demands them, leading to early closure of the trade and potential losses.
A synthetic short, on the other hand, obviates the need to worry about all of the above. And while there are certainly margin requirements on the short call side of the trade, they’re less onerous than the 150% required for a straight short sale. (It’s wise to check with your broker for exact details.)
Real Life Is the Best Teacher
With a clearer understanding that the synthetic approach is simpler in nearly every respect, let’s now turn to a real-life example to see how a synthetic short performs.
Here’s a chart of Bank of America (NYSE: BAC) for the last six months:
In mid-July, after a wild buying spree that sees the stock gap higher and add 15% to its market cap, you feel the move for Bank of America is overdone. You decide to put on a synthetic short because you want to avoid the hassle (and cost) of a straight short sale – and you have a hunch the whole thing may be opened and shut in a very short period of time.
So, when the stock hits $18, you act (red circle). You buy a September 18 put for $2.10 and sell a September 18 call for $2.30, for a total credit of $0.20.
Because of the credit, your break-even for the trade is $18.20. Anything above that level and you begin to lose money; anything below and you’re in the black.
A month later, you see you were on to something. The stock tanks, losing more than 20% in a week before closing at $15.55 at expiry.
The short call expires worthless and the put is $2.45 in the money. Add that to your initial credit and you’re up $265 ([$18 + $0.20 – $15.55] x 100).
Now consider a straight short sale, opened at $18 and closed for the same $15.55. The profit there would have been $245. It’s comparable, but it comes with all the aforementioned headaches.
Trading note: Remember that a synthetic short is a time-bound strategy that must achieve success within the lifespan of the option. It may not be appropriate for someone who is long-term bullish on a security or who is not confident of the timing of an expected dip.
Best of luck!
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