Options Trading Made Easy: Synthetic Short Call

We’re going to look at a synthetic short call strategy today, a position that mirrors the profit/loss profile of a short call.
The strategy is implemented by:

1. Shorting 100 shares of the underlying stock; and
2. Selling an at-the-money put against it.

Why would I want to do that?
There are as many reasons for implementing a synthetic short call as there are traders, but we’ll focus on just two.

Scenario No. 1

Let’s imagine it’s late May, and you decide to go short a put on General Motors (NYSE: GM). It’s the appropriate trade to make because earnings are strong, the stock looks poised to rise and you believe that writing some premium would be an efficient way of benefiting from the move.

With the stock at exactly $34.50 (red circle), you sell the at-the-money October 34.50 put for $2.50 and bingo, the stock begins to rise.
For six full weeks the trade looks safe, until one day in late July when bad news strikes – an important executive jumps to a competitor and the United Automobile Workers union sets a near-term strike date (black arrow).
The next morning the stock gaps lower, and you feel your profit is about to slip away. Volumes shoot higher, the financial press is negative and it appears the right trade was rather a short call, not a short put, as you had originally determined.
But what to do? To unwind the trade and rewrite a call would mean a great deal of commissions thrown out the window. What options do you have?
You go “synthetic”!
As the stock slides lower toward your original $34.50 entry point, you realize you have to act, lest your put end up in the money and you get assigned the stock. You immediately short sell 100 shares of GM at $34.50 (green circle), effectively turning your trade from a short put into a synthetic short call.
How’s that, you ask?
Let’s look at the numbers:

• The short put bagged you $250 in premium.
• But as the stock fell to close at $30.25 by expiry (blue circle), your put closed underwater by $425 ([$34.50 – $30.25] x 100).
• On the other hand, your short sale of the stock at $34.50 turned you an equal-sized profit of $425.
• All told, you’re left with a net gain of $250, your original premium on the trade ($425 – $425 + $250).

Now consider the alternative.
Had you simply sold an at-the-money 34.50 call instead of put at the outset, pulling in the same premium of $250, you’d have fared exactly the same.

Scenario No. 2

You’re short ABC stock and it sells off magnificently.
You believe there’s still more downside to the trade, but in the meantime you suspect it may be due for a bounce. Instead of closing the short and resetting it again later – a move that might have negative tax implications – you simply sell a put against the short and profit should the bounce indeed occur and should the underlying remain above the strike at expiry.
Below the strike, of course, you’re safe, because the short sale and short put simply cancel one another out (as in scenario No. 1).