What is a synthetic put?
A synthetic put is an option strategy that combines a short position on a long call option on the same stock to mimic a long put option. It is also called a long synthetic put. Essentially, an investor who has a short position in a stock buys a call option on the same stock. This measure is taken to protect against an appreciation of the share price. A synthetic put is also known as a married call or a protective call.
Key points to remember
- A synthetic put is an option strategy that combines a short position on a long call option on the same stock to mimic a long put option.
- Synthetic put is a strategy that investors can use when they have a bearish bet on a stock and are concerned about the short term potential strength of that stock.
- The objective of a synthetic put is to take advantage of the expected decline in the price of the underlying stock, which is why it is often called a long synthetic put.
Understanding synthetic Puts
Synthetic put is a strategy that investors can use when they have a bearish bet on a stock and are concerned about the short term potential strength of that stock. It is similar to an insurance policy, except that the investor wants the price of the underlying stock to fall, not rise. The strategy combines short selling of a security with a long-term position in the same security.
A synthetic put mitigates the risk that the underlying price increases. However, it does not deal with other dangers which may expose the investor. Because it involves a short position in the underlying stock, it carries all of the risks associated with an adverse or bullish movement. Risks include fees, margin interest and the possibility of having to pay dividends to the investor from whom the shares were borrowed to sell short.
Institutional investors can use synthetic put options to hide their trading bias, whether bullish or bearish, on specific securities. However, for most investors, synthetic put options are best suited for an insurance policy. An increase in volatility would be beneficial to this strategy while the temporal decrease would have a negative impact on it.
A simple short position and a synthetic put have their maximum profit if the share value falls to zero. However, any advantage of the synthetic put must be reduced by the price or the premium that the investor paid for the call option.
The synthetic sales strategy can place a practical ceiling, or ceiling, on the share price for a “commission”, the option premium. The cap limits any upside risk to the investor. The risk is limited to the difference between the price at which the underlying share was sold short and the exercise price of the option and any commissions. In other words, at the time of purchase of the option, if the price at which the investor sold the share was equal to the exercise price, the loss for the strategy would be the premiums paid for the option.
- Maximum gain = short selling price – lowest share price (ZERO) – premiums
- Maximum loss = short selling price – long-term strike price – premiums
- Breakeven Point = Short selling price – Premiums
When to use a synthetic put
Rather than a for-profit strategy, a synthetic put is a capital preservation strategy. Indeed, the cost of the call part of the approach becomes an integrated cost. The option price reduces the profitability of the method, assuming that the underlying stock moves in the desired direction lower lower. Therefore, investors should use a synthetic put as an insurance policy against short-term force in an otherwise bearish stock, or as protection against a higher unexpected price explosion.
New investors can benefit from knowing that their stock market losses are limited. This safety net can give them confidence by allowing them to learn more about the different investment strategies. Of course, any protection will have a cost, which includes the price of the option, commissions and possibly other fees.