Construction

The strategy consists of an ATM long put position and simultaneously an ATM short call position with the same number of options, on the same underline security, and identical expiration date.

 

 

 

It can be either a credit or a debit spread.

When to use

When we want to replicate an outright short stock position. It can be very helpful if a trader’s account isn’t large enough to take a desired short position in a stock.

The synthetic short stock strategy has the same risk profile and characteristics as an outright short stock position (see also the page ”put-call parity” for a better understanding why this happens).

Loss/Profit at expiration

Maximum loss: Unlimited because of the short call – net premium received (plus if paid) + commissions.

Maximum profit: Very high (until the stock goes to zero) + net premium received (minus if paid) – commissions.

Profit/Loss diagram

Below we can see the profit/loss diagram for the synthetic short stock strategy, which is just like an outright short stock position diagram. The strike price is $25, the call premium is $1 and the put premium is $0.50.

Synthetic short stock strategy example

In the daily chart of stock WFC (below) we have spotted a resistance at point A. The first time price is visiting this resistance (point B) we can apply the reversal strategy and open a short stock position. The market (SPY) is in a sideways trend and the same day it is also visiting a resistance, so the possibility of a reversal is augmented due to the effect of the market in stock prices.

The value of an outright short position on 500 shares, if we suppose that we sold short at $29.50, is $14,750 ($29.50×500). An account of $5,000 in cash isn’t able to open such a swing position due to certain leverage rules. We can replicate it by buying 5 ATM puts and simultaneously write 5 ATM calls with strike $30. If the put premium is $1 and the call premium is $1.50 then the net value of the position will be $250 [($1.50-$1)x500].