Synthetic short stock is a bearish synthetic option strategy with two legs. It replicates short position in the underlying stock, using a long put option combined with a short call option. Like short stock, it has unlimited loss and limited profit (although the profit can also be very large if underlying falls a lot).
To enter a synthetic short stock position:
- Sell a call option.
- Buy a put option with the same strike and same expiration.
- Sell the 65-strike call option for $3.58 per share ($358 for one option contract).
- Buy the 65-strike put option for $3.34 per share ($334 per contract).
Payoff from a synthetic short stock is identical to a short position in the underlying stock – the payoff diagram is linear and declines with increasing underlying price to a potentially unlimited loss.
Maximum profit is reached when underlying price falls to zero.
Basic requirement for a synthetic short stock is that the call and put strikes must be equal (if they are not, it is a short combo strategy).
The most common way to set up a synthetic stock (long or short) is using at the money strike (the strike closest to underlying price at time of position entry). Choosing a higher or lower strike does not change the payoff, but it does affect cash flow.
When using at the money strike, initial cash flow is very close to zero, as both the options have similar premium.
Synthetic short stock initial cash flow = call premium – put premium
This is different from plain short underlying position, where the cash amount initially gained from the short sale equals the entire stock price.
When choosing strikes other than at the money, initial cash flow shifts away from zero, as one of the options is in the money (and has higher premium) while the other is out of the money (with lower premium).