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The Synthetic Put option strategy allows for a known and limited loss when shorting stock.

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Strategy: Synthetic Put

a.k.a. Protective Call

Synthetic Put Option Graph

The Outlook: Bearish. The stock must fall by as much as the long call debit to have a gain.

The Trade: Short Stock and buy Long Call, OTM, using the next strike price above the current stock price.

Gains when: Stock falls enough by the expiration date to overcome long call debit.

Maximum Gain: Limited only by the stock price falling to zero.

Loses when: Stock goes up, does not fall, or does not fall enough by the expiration date.

Maximum Loss : Limited to the strike price - the short stock entry price + the long call debit.

Breakeven Calculation: Strike Price bought - short stock entry price - long call debit.

Advantages compared to short stock: Limited and known in advance possible loss.

Disadvantages compared to short stock: Slightly more stock movement needed to be profitable.

Volatility: After entry, increasing implied volatility is positive.

Time: After entry, the passage of time is negative.

Margin Requirement : None. Initial long call debit must be paid in full.

Variations: use ATM or ITM strike for the long call to simulate a Long Put, ATM or Long Put, OTM.

Synthetic Equivalent: Long Put, ITM.

Comments

  • This strategy might be used if you are comfortable shorting stock, but want protection if the stock should happen to rise.
  • One advantage over using Long Puts is that shorting stock brings cash into your account, which some brokers will pay interest on.

Exits

  • Since this is a bearish position, the trader is obviously expecting the stock to drop. If the stock does not drop, and the time to expiration gets to just a couple weeks, it is usually wise to exit the trade, taking less than the maximum possible loss.
  • If the trader is still bearish on the stock but feels he may have missed on the timing, the currently held long call can be "rolled" to one expiring in a later month. The currently held call will have some value, which will help offset the cost of the new call.
  • If the stock moves lower as expected, the trader can take gains by closing the trade, or rolling the long call down closer to the current stock price to protect more of the gains.

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