A Synthetic Short options strategy is named so because it is almost similar to a naked short PLUS it has the potential to make additional gains.
It works great in bear markets.
How To Play The Synthetic Short Strategy
The strategy involves
(a) SELLING an AT-THE-MONEY Call option
(b) BUYING an AT-THE-MONEY Put option
with the same expiration date.
Note that as the Call and Put options are to be traded at AT-THE-MONEY prices, it implies that the strike prices are equal to or very close to the CMP.
You should adopt this strategy for stocks you are bearish on. The idea is to gain from both the put that you have bought and the call that you have shorted.
Let’s start with an example.
It’s 21 May 2018, (12.30 PM) and a bearish stock we have identified is JUST DIAL.
Just Dial was selected because
(a) Results expected today and it is more a weak number
(b) Just Dial is a Google competitor and it does not stand a chance unless it rejigs its business model.
Its CMP is 422.
The 31-5-18 420 PE is 22
The 31-5-18 420 CE is 22
Let’s do the trade.
1,400 units in one lot, so the total investment works out to:
1,400 X 22 = 30,800 (at 100% margin, have excluded MTM losses, volatility and risk margins) (for the CE)
1,400 X 22 = 30,800 (at 100% margin) (for the PE)
Total = RS 61,600
It’s 1.25 PM now and the rates are:
The CMP is 417
The 31-5-18 420 PE is 23.50
The 31-5-18 420 CE is 21
We are gaining, so let’s book profits:
PE – 1,400 shares X 1.50 (23.50-22) = 2,100 per lot
CE – 1,400 shares X 1 (22 – 21) = 1,400 per lot
Net Profit = RS 3,500
We won’t wait for the results and book out now because the gains are fairly good. Know that you can make much more if the stock falls per your expectations.
Also, Just Dial is a volatile stock for which the Long Strangle should work better. Anyway, this too worked out.
UPDATE: At 3.30 PM, the situation was:
The CMP is 4o7
The 31-5-18 420 PE is 26
The 31-5-18 420 CE is 17
Had we squared up at 3.30 PM, our profits would have been:
PE – 1,400 shares X 4 (26-22) = 5,600 per lot
CE – 1,400 shares X 5 (22 – 17) = 5,600 per lot
Net Profit = RS 11,200
BUDGETING FOR LOSSES
Remember that trades can go wrong and therefore you always must work with a budgeted loss while playing options. If you are willing to lose no more than Rs 3,000 per trade, book out when your losses hit your targets.
When to Enter Into A Synthetic Short
- In extremely bearish stocks.
- In stocks that are bearish in the near term but can be bullish or neutral in the long run.
- When the general market is falling and declines outnumber advances by a wide margin.
Square up both options at the same time, preferably on the same day. Book out as soon as you make some money or hit your budgeted loss number.