Using Options to Simulate a Short Stock Position

Next week is not only the highly anticipated Fed meeting, it's also the historically weakest week of the year for stocks, and tends to trigger a CBOE Volatility Index (VIX) pop. According to Schaeffer's Senior VP of Research Todd Salamone, traders can hedge the broader equities market by picking up SPDR S&P 500 ETF (SPY) puts and/or VIX calls. Meanwhile, traders looking to make a bearish bet elsewhere could consider the synthetic short options strategy, which simulates selling a stock short.

A synthetic short is a good alternative for a would-be short seller who doesn't want to take the full risk of borrowing shares to short. With a synthetic short play, option players minimize the initial debit, at the cost of limiting the eventual pay-off in a "best case" scenario.

For example, imagine a trader thinks that Stock XYZ is on its way down – soon. XYZ is currently trading at $49.00. The trader may choose to open a synthetic short on the stock by buying to open a 50-strike put (at an ask price of $2) while also selling to open a 50-strike call (at the bid price of $1). By selling to open the 50-strike call, the trader can halve her cost of entry to $100 ([$2 - $1] x 100 shares per contract).

It's worth noting that strike selection plays a key role in whether this trade is initiated for a net debit or a net credit. Depending upon where the stock is trading in relation to the strike price, the call may occasionally be more expensive than the put, resulting in an initial net credit. However, since the synthetic short is inherently a bearish trade, it makes sense to back up that belief by choosing a strike where the put is worth more than the call.

In our example, the trader's maximum gain is the strike minus initial net debit, so $49, or $490 ([50 - $1] x 100 shares per contract). If XYZ plunges to $0 by the time the contract is exercised, the trader will profit this full amount. Of course, a less drastic change will still yield a profit, and the trader will begin to see a return once the stock drops below breakeven at $49 (strike price minus net debit).

If the trade was opened for a net credit, the maximum gain would be equal to the purchased put strike plus the net credit. Again, though, given the bearish nature of a synthetic short, this situation is less common.

It is important to note that one major drawback to a synthetic short is that there is unlimited maximum risk if XYZ rises above the strike price, since the initiating trader is short a call option. If the trade was initiated for a net credit, it would begin to lose money once the stock rises above a different breakeven level, which is equal to the strike plus the net credit.

In conclusion, the advantages of a synthetic short plays are: the sale of the call can partially or completely offset the cost of the put; you don't have to borrow shares from your broker; and the margin requirement on the short call is frequently smaller than the margin requirement for a traditional short sale. The unlimited risk involved in a synthetic short is a pretty serious con, though. On its own, a long put offers limited risk and carries no margin requirement -- two major advantages of buying puts over short selling.