What is a synthetic put?
A synthetic put option is an option strategy that combines a short position in stocks with a long call option on the same stock to mimic a long put option. It is also called a synthetic long. Essentially, an investor who is short in a stock buys a money call option on that same stock. This action is taken to protect against the appreciation of the share price. A synthetic sale is also known as a married call or a protection call.
- A synthetic put option is an option strategy that combines a short position in stocks with a long call option on the same stock to mimic a long put option.
- The synthetic put option is a strategy that investors can use when they have a bearish bet on a stock and are concerned about the potential short-term strength of that stock.
- The objective of a synthetic put option is to benefit from the anticipated fall in the price of the underlying stock, which is why it is often called a long synthetic put option.
Understanding Synthetic Puts
The synthetic put option is a strategy that investors can use when they have a bearish bet on a stock and are concerned about the potential short-term strength of that stock. It is similar to an insurance policy, except that the investor wants the price of the underlying shares to go down, not up. The strategy combines the short sale of a security with a long buy position on the same security.
A synthetic put option mitigates the risk of the underlying price rising. However, it does not address other dangers that can leave the investor exposed. Because it involves a short position in the underlying stock, it carries all the associated risks of an adverse or bullish market movement. Risks include commissions, margin interest, and the possibility of having to pay dividends to the investor from whom the shares were borrowed to sell short.
Institutional investors can use synthetic put options to disguise their trading bias, whether bullish or bearish, on specific securities. However, for most investors, synthetic put options are best suited for use as an insurance policy. An increase in volatility would be beneficial for this strategy, while a decrease in time would affect it negatively.
Both a simple short position and a synthetic sale have their maximum profit if the value of the stock falls to zero. However, any benefit from the synthetic call option must be reduced by the price or premium paid by the investor for the call option.
The synthetic selling strategy can place a practical ceiling, or cap, on the share price for a ‘fee’, the option premium. The limit limits any upside risk to the investor. Risk is limited to the difference between the price at which the underlying stock was short and the option strike price and any fees. In other words, at the time of purchase of the option, if the price at which the investor shorted the stock was equal to the strike price, the loss of the strategy would be the premiums paid for the option.
- Maximum Profit = Short Sell Price – Lowest Share Price (ZERO) – Premiums
- Maximum loss = short sale price – long option strike price – premiums
- Break-even point = Short sale price – Premiums
When to use a synthetic putty
More than a profit strategy, a synthetic put option is a capital preservation strategy. In effect, the cost of the calling portion of the approach becomes a built-in cost. The option price reduces the profitability of the method, assuming that the underlying stock is moving in the desired direction: lower and lower. Therefore, investors should use a synthetic put option as an insurance policy against short-term strength in an otherwise bearish stock, or as protection against an unforeseen price explosion.
Newer investors can benefit from knowing that their losses in the stock market are limited. This safety net can give them confidence as they learn more about different investment strategies. Of course, any protection will come at a cost, which includes the option price, commissions, and possibly other fees.