Synthetic Short Put

[Igor 10]

Traders who carry out a synthetic short put strategy are betting that the market price will go up for the shares owned in their portfolio. The technique involves writing (selling) call options for the owned underlying asset. The reason investors refer to this as a put strategy instead of a call is because the profit potential functions the same as it would in a short put approach. When implementing a synthetic short put, traders gain limited premiums as the market rises, but they expose themselves to unlimited loss risk when the market value of the option's underlying asset falls.

 

Definition of ATM, ITM and OTM for Synthetic Short Puts

There are three ways to define the relationship between a call option's strike price and the market price of its underlying asset. Understanding the differences between the terms is important because the risks involved in buying puts depend on these terms at the time of the purchase and when assigning assets.

 

ATM - At The Money: The underlying asset's market price equals the option's strike price.

Example:

- Put Option XYZJan50 (strike price $50)

- XYZ is trading at $50

 

ITM - In The Money: The underlying asset's market price is more than option's strike price.

Example:

- Put Option XYZJan50 (strike price $50)

- XYZ is trading at $60

 

OTM - Out of The Money: The underlying asset's market price is less than option's strike price.

Example:

- Put XYZJan50 (strike price $50)

- XYZ is trading at $40

 

How to Implement a Synthetic Short Put Strategy (ATM)

 

 

XYZ is trading at $50 (market price)

1) Trader buys 100 XYZ shares for $5000 (100 x $50 share cost)).

2) Trader writes (sells) a call option: XYZJan50($3)

- 100 shares of XYZ stock

- Strike Price $50 (ATM), expiring in 30 days

- Premium Cost of $3

3) Trader receives $300 from the buyer [100 x $3 (premium cost)].

Total Investment cost: $4700 ($5000-$300)

 

Result one: XYZ hits $55 (ITM). The call buyer exercises the option to buy 100 shares at $55. The call seller sells his or her 100 shares and receives at $5500 for a total profit of $800 ($5500 received from buyer - $4700 total investment cost).

 

Result two: XYZ hits $43 (OTM). The call buyer lets the contract expire. In this example, the option seller would keep the 100 shares and the $300 in premiums collected, but would suffer a $700 loss on paper ($4300 asset's worth -$5000 paid). The total loss reduces to $400 when adding the premiums received from the call.

 

Result three: XYZ hits $50 (ATM). The call buyer lets the contract expire. In this example, the option seller would keep 100 shares and the premiums collected for a total profit of $300 ($300 received in premiums).

 

Advantage and Disadvantage of a Covered Call Strategy:

 

Pluses: The upside to this type of strategy is that traders get to earn a limited premium on top of any gain on paper from their owned assets. Another advantage to the synthetic short put strategy is that premiums earned can reduce any loss incurred from a decline in the underlying asset's market price, down to the investment's break even point.

 

Minuses: The downside to implementing a synthetic short put strategy is that a trader's profits are limited to only the gain on paper plus the premiums received from the call buyer. The investor can not receive any profits from gains the underlying asset's market price because he or she would have sold the asset upon assignment. Finally, if the underlying asset's market value falls, the trader's risk becomes unlimited, as the asset's price could decline to a zero value.