Synthetic Short Stock – Higher Risk

Reversing the positions to short call and long put creates a synthetic short stock, and completely changes the risk.

This is because with a short call, market risk is higher. But there are ways to mitigate the risk.

A couple of examples based on the closing prices of June 14 and estimating a $5 trading fee for single options in each case:

            Amazon (AMZN) $1,723.86

            1725put, ask 18.50 = $1,855

            1725call, bid 17.95 = $1,790

                        Net debit = $65
 

            Chipotle (CMG) $460.44

            460put, ask 6.40 = $645

            460call, bid 6.40 = $635

                        Net credit = $10

In both cases, the leverage is attractive. For a net of $65, you take control of 100 shares of Amazon, trading above $`1,700 per share. In the case of Chipotle, you gain the same control for only $10, with the stock trading above $460.
 

The position performs well if the underlying price declines. By expiration, you gain one point in the synthetic position for each point of price decline below the strike. In either case, if the stock does decline, your return will be substantial.

This is a cheaper and better leveraged alternative to shorting stock or buying long puts without the leverage. However, that short call does present risk. Another factor to remember is that you need to have collateral posted in your margin account.

Collateral requirement is equal to 20% of the strike value, minus premium received for a short position. The short call on Amazon requires $36,175 in your margin account; and for Chipotle, the margin is $9,840.

To calculate margin in any short position, go to the CBOE free margin calculator.

The high leverage of this position makes it attractive, but the short call risk cannot be ignored. There are four ways to mitigate this risk:

1. Stock ownership. If you also hold a position in the stock, the uncovered call is converted to a covered call. This eliminates the market risk of the synthetic short stock trade. It also turns the position into a risk hedge, eliminating market risk below the strike. For example, if you set up an Amazon synthetic short stock like the one above, and the underlying price fell to $1,710, you lose 14 points in the underlying; but you gain 14 points in the long put, so the synthetic sets up an offset to protect your equity position.
    
2. Create a buffer between strike and price. The examples were all based on opening a synthetic at the money. You can also create a position with a buffer between the current price and the short call strike. For example, in the case of Amazon, you could pick a 1742.50 strike for the short call, receiving premium of 10.60 (net $1,055). The long put could be opened at a 1705 strike, costing 10.50 (total $1,055). In this case two adjustments are made. First, you pay $775 net debit for the synthetic and gain a buffer of nearly 19 points. Second, your downside protection in the long put starts at the lower strike of 1705, so your risk exposure is also about 19 points. By diagonalizing the synthetic, you get a risk reduction on the short side, and a modified risk hedge on the long side.
    
3. Use short-term expiration. By focusing on extremely short-term expirations, time decay helps reduce short call risks, while still providing downside protection. In the examples, a 7-day term until expiration was used. Time decay between Friday 6/15 and Monday, 6/18 is expected to be substantial, usually about one-third of remaining time value.
    
4. Time entry for underlying movement above resistance. When price breaks out above resistance, especially with a gap, it is most likely to retrace back into range. By timing entry of the synthetic short stock to this moment, you maximize potential for short-term profits while reducing the risk of short call exercise.
    

The synthetic short stock is a promising trade in terms of risk hedging; but managing the exercise risk also needs to be part of the strategy. Combining synthetic short and long stock positions as part of a highly leveraged swing trading strategy is an effective technique as well.

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.