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We know that a short put is a means for a bullish trader to garner some premium as the market moves higher. But what’s the purpose of a “synthetic short put,” a strategy that mirrors the profit/loss profile of a short put?
As with most synthetic strategies, the answer lies in the realm of time. That is, we may have a notion of which way a stock is headed, and we may be right. But options trading means we have to be correct with our timing, too. The synthetic strategies afford us a means of playing our options cards in a less time-dependent manner.
Let’s look at an example that helps highlight that point, while at the same time illustrates the ins and outs of the synthetic short put strategy itself.
All Aboard the UTX Express!
After watching United Technologies (NYSE: UTX) take a nasty spill through July, you believe the decline is not yet over. All your research and instincts tell you that selling a call is the proper course of action.
You hold off doing anything as the shares rise through August. Then, on the first of September, you strike (red circle). You sell the at-the-money December 109 call for $5 and for the next six weeks you’re in money heaven. United Technologies declines below $100 and you begin to fantasize about buying a Porsche.
But then fortune turns, and lo! the stock starts rising just as quickly as it fell. You’re convinced it’s a temporary affair, but by early November, with almost all of your profits whittled away, you’re forced to admit you were wrong and look to take protective action. As the stock hits $109, you purchase 100 shares of United Technologies, and in so doing, flip your original short call into a synthetic short put.
Before I explain how that happened, let’s look at a few basics.
To begin, a synthetic short put is constructed by:
- Purchasing 100 shares of the underlying stock; and
- Selling an at-the-money call against it.
Your last minute evasive action (buying the shares) accomplished exactly that.
Identical Profit/Loss Profiles
As the stock rises to close at $117 by December expiry, your long shares are up exactly $8, offering you exactly $800 in profits. But your short call is in the money by the same amount, $8, creating a loss of $800. It’s a perfect wash, save the initial $500 credit you garnered when you sold the call.
Compare that to an at-the-money put option sold for $5 instead of your original call. In that scenario the put would have expired worthless – and you would have pocketed the selfsame $500 by December expiry, as you did with the synthetic short put.
And what if the trade went awry?
Both the synthetic short put and straight short put would have offered downside protection through the $104 level for United Technologies stock ($109 – $5).
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