kleemc's  Instablog

Further on my previous blog post about the benefits of using options to create a synthetic long stock position, the same technique can be used to short stock. The benefits though are slightly different and arguably more.

Firstly, a synthetic short stock position can be established by simultaneously holding a short Call and a long Put of the same strike, same expiration of a particular stock. The benefits of holding a synthetic position instead of a short stock position are :

1. No need to borrow stock. As anyone who short stock frequently knows, stocks are not always available to be borrowed when you need it. That's very frustrating. You could have waited patiently for months before a stock finally reached the desired price level. Then you hit the wall - there is no stock available anywhere to borrow from. The synthetic position, on the other hand, does not involve borrowing. Therefore, you can enter the synthetic position any time you wish.

2. No interest charged. Since the synthetic position does not involve borrowing of stocks, there is no admin fee and no interest charged, other than the normal commission for trading the options.

3. Lower margin required. Same as synthetic long position. The synthetic short position requires lower margin than shorting the stock outright. The actual difference in margin required will depend on the broker and the type of account you have.

4. No Short squeeze. Again, as there is no borrowing of stocks, there is no chance of anyone demanding the return of the borrowed stocks.

5. No dividend payout. I guess this is the biggest benefit in my opinion. If you short a dividend carrying stock, you would have to pay the stock owner the dividend when it is due. This is a risk. But this is a non-issue for the synthetic position.

I don't do much shorting but sometimes when I do, I always prefer to go with synthetic. It may sound complicated and risky but it really isn't. Once you have done it once, you'll know it's really simple and straight forward, minus the risk and hassle of shorting stock outright.

There is a better way to hold stocks for the long term, and that's by buying a Call option and Selling a Put option at the same strike price and with the same expiry simultaneously. This strategy is commonly called synthetic long stock. A simple description of the strategy is listed here

Why is it better ? To me two main reasons :

(1) it requires less capital to achieve EXACTLY the same result as buying and holding a stock outright. Typically, a synthetic position only requires less than 50% of the capital required for holding stocks, depending on how far away is the expiration date and what are the strike prices.

(2) at times, when the Put premium is higher than the Call premium, the break even point of the synthetic position might be even lower than the stock. Meaning if the stock is trading at $100. Break even point for the stock is obviously $100. But the synthetic position might have a break-even point of $95. It's possible. I'll give an example below.

What about risks? No more, no less risk. Some people freak out when they hear "selling Put option naked". People have read about the risk of selling Put option naked. It's true. Selling Put option naked has unlimited downside risk but so does buying stock and holding it long term.

What I'm assuming is the same value investing discipline is practiced. If that is the case, then the synthetic long stock position has ZERO additional risk compared to holding stock. The P&L of the two positions will be identical at expiration. The key word to stress here is "at expiration". Meaning if you choose a 6 months option, you must be prepared to hold it till expiration because along the way, the implied volatility of the Put / Call options might change and there is no telling how the interim P&L will behave.

Example : Let me use WPRT, Westport Innovations as an example. I chose this stock purely because it has a hugely imbalanced Put / Call premium which I can use to illustrate the concept of a lower break even point. I am not suggesting at all that this is a value stock I would invest in.

At the closing on Feb 22, 2013, WPRT Stock Price = $30. January 2015, $30 Put has a mid price of $10.10. January 2015, $30 Call has a mid price of $5.10.

To construct a synthetic long position, buy 1 lot x 30 Call and Short 1 lot x 30 Put. So, pay $5.10 and receive $10.10. Net premium = + $5.00. However to do this position, option brokers will require margin for the naked short Put. Margin simply means the amount you have to set aside in your account, which your broker will not allow you to trade with.

I keyed the position into my broker's option analyzer platform and I got $1,407. That means a synthetic long position equivalent to 100 stocks of WPRT will cost me $1,407 , whereas if I buy the stock outright, I would have to pay $3,000. That means only 47% of my capital is used for a position that gives me the same risk/reward as the long stock.

In addition, this position gives me a significantly lower break-even point. At expiration, if WPRT stays unchanged at $30. I will pocket the $5.00 premium (see above). Isn't it great to be able to profit even when the stock hasn't moved at all ? Yes this is absolutely true. No gimmicks here.

In fact, the $5.00 premium is mine to keep regardless what the stock price does. However, if the stock price moves down, I will incur losses of the same amount as I would holding the long stock. However, I have the $5 premium to offset with. Therefore my true break even point is $30 - $5 = $25. If the stock stays above $25, I gain. Below $25, I lose. That is way better than buying the stock outright at $30 now, isn't it?

I believe synthetic options can help stretch a value investor's capital, an important advantage for retirees. But ... one must thoroughly understand what he's doing before jumping in with both feet. The beauty is there are many free broker platforms you can do paper trades with. Do lots of practice. It's free and no risk. Convince yourself that synthetic options give you exactly the same results as holding stock outright. Convince yourself that you can profit with paper trades, then start to gradually migrate your long stock positions into synthetics.

Maybe this technique can help you retire earlier with the same amount of planned capital.