What Is a Synthetic Put?
A synthetic put is an options strategy that combines a short stock position with a long call option on that same stock to mimic a long put option. It's also called a synthetic long put. Essentially, an investor who has a short position in a stock purchases an at-the-money call option on that same stock. This action is taken to protect against appreciation in the stock's price.A synthetic put is also known as a married call or protective call.
Key Takeaways
- A synthetic put is an options strategy that combines a short stock position with a long call option on that same stock to mimic a long put option.
- Synthetic puts are utilized when investors have a bearish bet on a stock and are concerned about potentialnear-term strength in that stock.
- A synthetic put's goal is to profit from the anticipated decline in the underlying stock's price, which is why it is often called a synthetic long put.
Understanding Synthetic Puts
The synthetic put is a strategy that investors can utilize when they have a bearish bet on a stock and are concerned about potentialnear-term strength in 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 the short saleof a security with a long-call position on the same security.
A synthetic put mitigates the risk that the underlying price will increase. It does not, however, deal with other dangers, which may leavethe investor exposed.Because it involves a short position in the underlying stock, it carries with it all those associated risks—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 puts to disguise their trading bias—be it bullish or bearish—on specific securities. However, for most investors, synthetic puts are best suited for use as an insurance policy. An increase in volatility would be beneficial to this strategy while time decay would impact it negatively.
The maximum profit for both a simple short position and a synthetic put is if the stock's value falls to zero. Note that any benefit from a synthetic put must beweighted against the options' premium.
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A synthetic put strategy helps protect against an increase in the stock's price, effectively putting a cap on the stock price. The cap limits upside risk for the investor (i.e. the risk that the short position's stock price rises).
The risk of a synthetic put strategy is limited to the difference between the price at which the underlying stock was shorted and the option'sstrike price (as well as any commissions). Put another way, at the time of the purchase of the option, if the price at which the investor shorted the stock was equal to the strike price, the loss for the strategy would be the premiums paid for the option.
- Maximum Gain = Short sale price - Lowest stock price (ZERO) - Premiums
- Maximum Loss = Short sale price - Long call strike price - Premiums
- Breakeven Point = Short sale price - Premiums
When to Use a Synthetic Put
Rather than a profit-making strategy, a synthetic put is a capital-preserving strategy. With that, the cost of the call portion (the option premium) becomes a built-in cost. The option's price reduces the profitability of the method—assuming the underlying stock moves in the desired direction, lower.
Thus, synthetic puts are often used as insurance policies against short-term spikes in stock prices (in an otherwise bearish stock), or as a protection against an unforeseen move upward in the stock price.
Newer investors may benefit from knowing that their losses in the stock market are limited. Thissafety net can give them confidence as they learn more about different investing strategies. Of course, any protection will comeat a cost, which includes the price of the option, commissions, and other possible fees.
