Wednesday, 8th September 2010

Synthetic Shorts

Written by George Traganidas Topics: Articles, Options, Wealth Building
By Jeff Fischer
August 10, 2009

Feeling bearish? If you’re looking to profit when stock prices slip, there’s a way to use options to mimic shorting a stock — but with distinct advantages. To set up this “synthetic short” position, you sell a call option and simultaneously buy a put option, using the same strike price and expiration date for each. Unlike a covered call strategy (detailed in Writing Covered Calls), in this case you do not own the underlying stock, so when you sell (or write) the call, it’s a “naked” call.

That means, just as when you short a stock outright, your potential losses are unlimited with synthetic shorts — so this is a risky strategy. But your potential profits are hefty, and the strategy provides advantages when compared to traditional shorting.

First, you don’t need to borrow shares of a stock to short it when using options — often, the stocks you want to short most are the most difficult to obtain for a traditional short sale. Second, the amount of money you need to risk up front is typically much smaller with a synthetic short, given the leverage provided by options. Third, unlike when you short a stock outright, you don’t need to cover any dividend payments yourself. Finally, both opening and closing a synthetic short can be done quickly, while the traditional shorting method sometimes involves a lot of waiting. To get a handle on how this strategy works, let’s run an example.

Sell a Naked Call, Buy a Put

Brave soul that you are, let’s say you want to bet against one of Warren Buffett’s recent investments. Volatile Goldman Sachs (NYSE: GS) has jumped to $100 per share, and you believe there’s profit to be had by shorting it over the next few months (remember, shorting usually involves a narrow time frame). Borrowing shares to short is difficult, and the stock pays nearly a 2% dividend — which you don’t want to cover yourself — so a synthetic short is your best route.

Although your shorting thesis only covers a few months, you want to use LEAP options so you have more time to be correct if need be. Choosing options that are as close to Goldman’s current share price as possible, you simultaneously sell the January 2011 $100 calls (which will pay you $32 each) and buy the January 2011 $100 puts (which will cost you $29). This results in a $3 per share credit to you. You’re now effectively short Goldman Sachs — and Buffett (how do you even sleep at night?).

In the ideal situation for you, Goldman declines 20% or more over the next few months and pushes both your calls and puts toward sizable profits. Your thesis has played out, and you should close your position — both options — profitably while you can.

The terrifying outcome (here’s that risk we mentioned) would be if Goldman soared. Your options would show large losses, and you would either need to take your lumps and close them or wait and hope for Goldman to fall. Because you have naked calls, by their expiration you’ll be required to buy Goldman stock at the going market price if it sits above $100 per share, and then deliver the shares at $100 per share for an instant loss — just as if you’d shorted the stock outright.

Another risk with an underwater call option is that it could be exercised early, forcing you to buy the stock and deliver it sooner than you wanted. It’s rare that an option is exercised early, but — especially when you don’t own the underlying shares — you need to be aware that it could happen. You also need to maintain enough buying power to cover your naked call obligations, and those broker requirements will be updated daily if the stock increases against your position.

Splitting the Strikes

If this example sounds too risky, you can add a little breathing room to your synthetic short by “splitting the strikes” (we covered this in our Synthetic Long Guide as well). To do this, you still sell your naked calls and buy your puts with the same expiration date, but you use different strike prices.

For example, rather than using the $100 strike price, assume you sell the January 2011 $115 calls on Goldman for $24 each and buy the $85 puts for $24 each. This gives you a sleep-aiding 15% window before your naked call’s strike price is hit. The lower strike on the put does make it more difficult to ultimately profit from the stock’s decline, but in the short term, the $85 put will move nearly as much as the $100 put when Goldman declines. So, it’s still attractive, and you’re still effectively short Goldman, but with less risk.

Just Buy the Puts

Remember, you can also invest against a stock by simply buying put options on it and foregoing selling naked calls to finance your put purchase, as we discussed in Options for Beginners. Sure, you need to come up with all the money to buy the puts yourself, and if you’re wrong on the trade, most or all of that money will be lost. But that’s the most you can lose with a put purchase, so your risk is known. You won’t have to worry about the potentially unlimited losses that a naked call entails.

Bottom Line

Despite the recent rout, the market’s long-term trend remains up, so a Foolish investor should only “go short” carefully and in special situations. Business is Darwinian by nature, companies come and go every year, and synthetic shorts provide a way to invest against the losers. We prefer to short companies with high debt, weak or no profits, few growth prospects, a low CAPS score, and inflated valuations. A synthetic short is also well-suited for shorting a market index to hedge your portfolio. Naturally, an index doesn’t present as much upside risk as an individual company. In closing, while synthetic shorts are as risky as selling short outright and shouldn’t be taken lightly, the advantages of the strategy over straight shorting earn it a rightful place in our tool box.

Synthetic Shorts Synopsis

  • To replicate shorting a stock with options, you sell a naked call and buy a put option simultaneously.
  • For a straight synthetic short, you sell a call and buy a put with the same strike price, the one that is as close to the current share price as possible.
  • Use the same expiration date for both the call and put.
  • Be careful — selling naked calls is risky! The higher the stock goes, the greater your potential loss.
  • Use LEAPs so you have more time to be proven right.
  • Once you have your desired profit, close the options — shorts usually involve a narrow time frame.
  • To take on less risk, “split the strikes” and use a higher call strike price.
  • Consider synthetic shorts on indexes (like SPY) as a portfolio hedge.
  • For less risk shorting with options, simply buy puts and forego writing naked calls.
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