Facebook
Twitter
When a stock is on the verge of taking a nosedive, most investors believe they have two options by which to profit – either a short sale or the purchase of a put option.
And under the circumstances, those strategies would certainly work. But there’s another alternative available – a “synthetic” put option, as it’s termed – that has the same profit/loss profile as a straight put purchase.
Let’s first examine what it is, and then figure out when and why one would employ it.
Constructing a Synthetic Long Put
To begin, a synthetic put is created by:
- Shorting 100 shares of the underlying security; and
- Purchasing a call option against the sale (usually an at-the-money call).
Combined, these two components create the exact risk/reward profile of a straight long put.
But why, you may ask, would anyone undertake such an initiative? Why add the call option at all? What benefit is derived therefrom? Why not just leave the short sale in place? After all, a short sale and a put produce similar results, no?
Indeed, they do. So let’s consider the “why.”
A synthetic put is generally established for one of the following reasons:
- A trader is short a stock and in a profitable position, but the shares are looking oversold and ready to bounce. He buys a call to avail himself of some profits over the short term, but still maintains the short for when the stock resumes its decline.
- A trader initiates a synthetic put position because he believes in the longer-term weakness of a security but isn’t sure exactly when the drop will ensue. He buys the call simply to protect himself in case he’s wrong in the near term.
Now let’s turn to a real-life example to see the strategy in action.
Below is a chart of the iShares Transportation Average (NYSEArca: IYT):
After a few steep drops in the index in January and poor corporate guidance numbers, you believe the time is ripe for the transports average to fall. All your research suggests that orders are also slowing, but you’re unclear as to when exactly the stocks will succumb.
Instead of going short the index altogether, you feel it’s more prudent to initiate a synthetic put, so that you’re both covered in the event of an upside surprise and not limited in time by a straight put purchase.
At the beginning of February, with IYT at $153, you short 100 shares of the stock and buy an at-the-money July 153 call option for $3.75 (red circle).
But instead of falling further, the transports swing as high as $164, and over the next four months it’s unclear whether your call was the right one.
Profit Delays? No Worries
Not until late May is it clear you’re going to make some money. And in the meantime, as we’ll soon see, the open call option had you covered.
The call expires in July, and you eventually cover your short in September at exactly $138. Your gain is $1,125 ($15,300 – $13,800 – [$3.75 x 100]).
Had you simply bought an at-the-money 153 put for $3.75, your profit would have been the same ([$153 – $138 – $3.75] x 100).
But what if the trade went sour and you were forced to close out at the late February 164 highs? Your short sale would have been in a losing position to the tune of $1,100. But the long call would have given you exactly the same $1,100 profit ([$164 – $153] x 100). You would have lost only your $375 premium for the call.
And that’s precisely what you would have ceded with the purchase of an at-the-money long put.
Best of luck, traders!
The three most profitable days of your life?
On each of these specific days, you could be making thousands of dollars in extra cash. With minimal risk. So get out your calendar…and get ready to step behind the curtain…and into a world of fast, easy money few investors will ever see. Click here to discover it.