Synthetic Long Put

[Igor 10]

Traders who implement a synthetic long put strategy are betting that the market price of an option's underlying asset will fall. The technique involves short selling owned assets and selling an ATM call option, hoping that it will expire OTM. Traders who employ this type of bear option strategy pay a premium to enter the market. However, gains from their call purchase will offset any potential loss from the short sale, thus, limiting the trader's losses. On the contrary, an investor's profit potential is infinite. If the market price crashes, traders who use this strategy can earn substantial gains.

 

Moneyness Review for Calls

 

Out-of-The Money (OTM) = Strike price (more than) Market Price

In-The-Money (ITM) = Strike price (less than) Market Price

At-The-Money (ATM) Strike price (equals) Market Price

 

How to Carry out a Synthetic Long Put

 

 

Disney stock is worth $40 (market price) in June.

1) Trader short sells 100 shares of Disney stock.

2) Trader buys the call option: DISJul40($2)

- 100 shares of Disney stock

- Strike Price $40, at-the-money (ATM), expiring in 30 days

- Premium Cost of $2

3) Trader pays a total of $200 to enter the market. [$200 (paid to purchase one call option)]

Total cost to enter the market: $200

Result one: Disney stock falls (crashes) to $30 in July.

a) The call option purchased expires worthless (OTM).

b) The short sale realizes a $1000 gain, and the trader receives $1000.

c) The trader makes a total profit of $800 after subtracting the cost to enter the market. [$800 = $1000 (gain from short sale) - $300 (to enter the market)]

 

Result two: Disney stock rises (rallies) to $50 in July.

a) The short sale realizes a $1000 loss, and the trader pays $1000.

b) The call option sold expires ITM.

c) The trader exercises his or her right to buy 100 shares at $40 from the person who sold the call option. The trader pays $4000 to the buyer, and receives 100 Disney shares.

d) The trader immediately sells the 100 shares in the open market and receives $5000.

e) The trader losses $200 after adding the cost to enter the market. [-$200 = $5000 (received for 100 shares) - $4000 (paid for 100 shares) - $1000 (loss from short sale) - $200 (cost to enter market)]

 

Result three: Disney stock falls (moderately) to $38 in July.

a) The call option purchased expires worthless (OTM).

b) The short sale realizes a $200 gain, and the trader receives $200.

c) The trader makes a total profit of zero after adding the cost to enter the market. [$0 = $200 (gain from short sale) - $200 (to enter the market)]. Thus, $38 serves as this strategy's breakeven point, with any market value lower than $38 resulting in profits for the trader.

 

Advantages and Disadvantages in Carrying Out A Synthetic Long Put

 

Pluses: The upside to this type of strategy is that investors limit their losses when things go wrong. They also enter the market knowing where their break even point stands. Finally, the synthetic long put strategy gives investors the opportunity to realize large profits at a low and limited risk.

 

Minuses: The only downside in carrying out this strategy happens when the market rallies and the call option expires ITM. However, investors would only lose what they paid in premiums to enter the market.