You might believe that the market as a whole, or for a specific stock, is bearish. However, you do not want to risk shorting stock because it is both expensive and risky. There is a solution that has very little risk and costs nothing or close to it.
Hard to believe? It's true. Synthetic short stock is an options position that acts exactly like shorted stock. It consists of a short call and a long put, written at the same strike and expiration. The cost of the long put is offset by the income from the short call and in most instances the net cost is at or close to zero. It may even produce a small net credit.
Risk is lower because with the options at zero cost, the major risk is found in the short call. If the stock's market value falls, the short call becomes worthless and the long put's value grows one dollar for each dollar of decline in intrinsic value (stock price below the strike). However, if the stock's price rises, the put becomes worthless and the short call is in danger of exercise. But you have a few things going for you that you do not have when you short stock. First, the short call's time value declines as expiration nears, so the short position often can be closed at a profit. The position can also be rolled forward to a later exercise date, a move that produces more premium income. Finally, the short call can be covered by the purchase of a long call or 100 shares of stock. None of these strategies are possible with short stock.
Another way to set up synthetic short stock is through a collar. In this strategy, you still have the short call and the long put. However, you also own 100 shares of the underlying stock. The collar gives you many additional benefits. If the short call gets exercised, the stock is called away at a profit (assuming the strike is higher than your original stock basis). Second, you earn dividends as long as you own stock by the ex-dividend date. Third, the offsetting option positions are still at or near zero cost. And finally, if your stock declines in value, the long put provides downside protection point for point below the strike.
The synthetic short stock position, whether involving an uncovered short call or a covered call within the collar, is an intriguing alternative to two other positions: Shorting stock, which is expensive and high-risk, or buying puts for insurance, which requires payment of a premium for protection only until expiration.
Like many options-based strategies, synthetic short stock solves problems of both cost and risk. It and its opposite strategy, synthetic long stock, deserve serious consideration as viable strategies to manage your portfolio and to take up positions with little or no added market risk.
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