Insurance is an inescapable part of life. If you’re reading this, you probably have several premiums built into your monthly budget — health insurance, life insurance or auto insurance. Some types of insurance are optional, like life or long-term disability insurance. Others are mandatory, such as homeowners insurance for mortgage borrowers or auto insurance for anyone who wants to drive a car.
Investors can also protect capital in a similar manner through hedging positions. But this strategy isn’t an insurance policy; instead, investors can purchase specific options to hedge their long or short stock positions. One of these strategies is the synthetic put, which offers short sellers some protection on the upside in case the stock starts moving higher. In this article, you’ll learn how synthetic puts (and calls) can be used against your holdings.
What Is a Synthetic Put?
A synthetic put is a bearish market strategy used when an investor expects the underlying stock to decline. Synthetic puts are created by making two separate trades — shorting a stock and purchasing a call option at or near the money on that stock.
If the stock declines in value, the short position gains while the call option loses. However, if the stock appreciates, the short position suffers losses while the call option gains. Investors with a bearish thesis can use synthetic puts to help protect their position against a sudden upswing in the underlying stock. A synthetic put acts similarly to a long put option; however, with this strategy, investors will still control their short stock position if the call expires worthless.
To calculate the theoretical maximum gain from a synthetic put, you subtract the option premium and the lowest possible stock price (i.e., zero) from the short sale price. If the stock goes to zero, synthetic put investors may achieve maximum profit. Conversely, investors can calculate a synthetic put’s theoretical maximum loss by taking the selling price of the stock (where it was sold short), less the purchase price of the stock (the strike price), and less the premium paid for the call option.
How Does the Synthetic Put Work?
Here’s an example of a synthetic put in action. Suppose you’re short 100 shares of ZZZ stock, a fictional company. The company is announcing quarterly earnings soon, and you want to hedge your short position against any unexpected good news. Since you already control a position that will appreciate if the stock declines, you purchase an at-the-money call option that will appreciate should the stock go up.
If the earnings report is as dour as you expect, your short position will likely go up, and the call option will expire worthless. But if the company beats estimates, the call options will offset some losses on the short position. You can also exercise the call option to close the short position if you want to exit the trade altogether.
When to consider the Synthetic Put Strategy
The synthetic put acts like a long put option, so this strategy should be used against an unexpected rise in the price of the underlying stock. Earnings reports, drug trial results, economic news or a short squeeze could trigger rallies that would otherwise wreck a simple short position. Using a call option in conjunction with your short position can help protect your capital from a significant upward move.
Synthetic Put vs. Synthetic Calls
The mirror image of the synthetic put is the synthetic call. As you may assume, a synthetic call is on a long stock position. If you are long 100 shares of fictional ZZZ stock and want to help protect your investment from a downturn, you can purchase an at-the-money put option. If the stock unexpectedly declines, the gains of the put option can help offset the losses from the long stock position.
Synthetic calls and synthetic puts are protective investment techniques best used in unpredictable markets. However, both strategies limit the upside of an individual long or short stock, so they should be applied promptly and strategically.
Potential Advantages of Synthetic Puts
Here are a few of the potential perks of adding synthetic puts to your trading repertoire:
Protection from a violent upswing in the underlying stock price
Allows investors to alter trading thesis without closing the original short position
Minimizes the number of transactions needed to adjust a position, which in turn minimizes trading expenses
Considerations When Using this Strategy
Remember that a synthetic put is an options strategy meant to limit risk by altering the parameters of a trade. For example, if the market trend changes or something unforeseen occurs, investors can pivot quickly using synthetic options instead of buying or borrowing more stock, which can reduce trading costs or capital requirements. But this strategy will limit the potential maximum profit on the original position, so consider the pros and cons before building a synthetic position.
Synthetic Puts Limit Upside But Protect Capital
A synthetic put can be a helpful asset in certain situations, and risk-averse investors often prefer them in times of uncertainty. Synthetic puts are protection against unexpected market moves, but you should only use them in specific situations. Investors using synthetic call or put options are purposely limiting the maximum profit of a that particular trade. Only use synthetic positions if you’re confident your original thesis needs tweaking.
Frequently asked questions
Advanced options strategies like synthetic puts can be confusing. Here are a few commonly asked questions regarding synthetic positions:
1. How do you make a synthetic put?
A synthetic put is constructed through two different trades. First, a short stock position is opened, followed by a long call option on the same stock. These two positions work in unison to create a synthetic put.
2. Is a covered call a synthetic put?
While a covered call is another type of protective trade, it differs from a synthetic put. A covered call requires writing a call option on a stock you already own. A synthetic put is a combination of a short stock position and the purchase of a call option.
3. Why use a synthetic put?
A synthetic put can be against losses should short-term expectations of a position change. Instead of purchasing stock to offset a short position, investors can use a call option to reduce the amount of capital required to alter their position.
