Synthetic Short Positions

A synthetic short position is a trading strategy used to replicate the financial outcomes of a traditional short sale without actually borrowing and selling the underlying asset.

This strategy is typically created using options and futures contracts.

Below is a detailed explanation of synthetic short positions, their components, and how they function.

Key Takeaways – Synthetic Short Positions

• Synthetic short positions allow traders to profit from, or hedge against, falling asset prices without borrowing the underlying asset.
• They are created by combining options or futures contracts.
  • This provides leverage and risk management advantages.
• Proper strategy and risk management are important to avoid potential unlimited losses associated with synthetic shorts.

Components of Synthetic Short Positions

Options

Options are financial derivatives that provide the buyer with the right, but not the obligation, to buy or sell an asset at a specified price within a certain time frame.

There are two main types of options involved in creating synthetic short positions:

1. Call Options: Gives the holder the right to buy an asset at a predetermined price (strike price) before the option expires.
2. Put Options: Gives holder the right to sell an asset at a predetermined price before the option expires.

Futures Contracts

Futures contracts are agreements to buy or sell an asset at a future date for a price that is agreed upon today.

These contracts are standardized and traded on exchanges, providing a mechanism for hedging or speculating on price movements.

Creating a Synthetic Short Position

A synthetic short position is constructed by using a combination of options that together mimic the payoff profile of a traditional short sale.

The two primary methods are:

Method 1: Short Call and Long Put

1. Short Call: Selling a call option obligates the seller to deliver the underlying asset if the option is exercised by the buyer. This position benefits from a decline in the asset’s price.
2. Long Put: Buying a put option provides the right to sell the underlying asset at a predetermined price. This position gains value as the asset’s price falls.

By combining a short call and a long put on the same underlying asset with the same expiration date and strike price, the trader creates a synthetic short position.

The net effect is similar to short selling the asset directly: profit is made if the asset’s price decreases, and loss is incurred if the price increases.

The short call helps fund the long put.

Moreover, higher interest rates tend to provide more of a net credit on the trade.

Method 2: Short Future Contract

Alternatively, a synthetic short position can be created using a futures contract:

1. Short Futures Contract: Entering into a short futures contract obligates the trader to sell the underlying asset at a future date for the agreed-upon price. This position benefits from a decline in the asset’s price.

Advantages of Synthetic Short Positions

No Need for Borrowing

Unlike traditional short selling, synthetic short positions don’t require borrowing the underlying asset.

This can avoid the associated costs and constraints.

Leverage

Options and futures allow for significant leverage.

This enables traders to control a large position with a relatively small investment.

Flexibility

Synthetic short positions can be tailored to specific market views and risk tolerances through the selection of different strike prices and expiration dates.

Risks & Considerations

Complexity

Constructing and managing synthetic short positions can be more complex than traditional short selling.

Requires a thorough understanding of options and futures.

Margin Requirements

Both options and futures positions may have margin requirements.

These can fluctuate based on market conditions and can lead to margin calls.

Time Decay

Options, especially near expiration, are subject to time decay, which can erode the value of the position over time.

Market Volatility

Synthetic short positions are sensitive to market volatility, and unexpected price movements can result in losses.

To illustrate how synthetic short positions are constructed and traded, let’s consider two detailed examples:

• one using options
• one uses a futures contract

We’ll go step by step and specify the amounts involved in each trade.

Example 1: Synthetic Short Position Using Options

Trade Details

• Underlying Asset: Stock XYZ
• Current Stock Price: $100
• Strike Price: $100
• Expiration Date: 1 month from today
• Number of Contracts: 1 (each contract typically represents 100 shares)

Step-by-Step

Sell 1 Call Option:

• Action: Sell (write) 1 call option on Stock XYZ.
• Strike Price: $100
• Expiration Date: 1 month from today
• Premium Received: $3 per share
• Total Premium Received: $3 * 100 shares = $300

Buy 1 Put Option:

• Action: Buy 1 put option on Stock XYZ.
• Strike Price: $100
• Expiration Date: 1 month from today
• Premium Paid: $2 per share
• Total Premium Paid: $2 * 100 shares = $200

Net Cost of the Trade

• Net Premium Received: $300 (received from selling the call) – $200 (paid for buying the put) = $100

Profit and Loss Calculation

If Stock Price Falls to $90:

• Short Call: The call option expires worthless, so no obligation to sell shares.
• Long Put: The put option allows selling the shares at $100, while the market price is $90.
• Profit from Put: $100 – $90 = $10 per share * 100 shares = $1,000
• Net Profit: $1,000 + $100 (net premium) = $1,100

If Stock Price Rises to $110:

• Short Call: The call option is exercised, obligating to sell shares at $100, while the market price is $110.
• Loss from Call: $110 – $100 = $10 per share * 100 shares = $1,000
• Long Put: The put option expires worthless.
• Net Loss: $1,000 – $100 (net premium) = $900

Example 2: Synthetic Short Position Using Futures

Trade Details

• Underlying Asset: Commodity ABC
• Current Futures Price: $500 per unit
• Number of Contracts: 1 (each contract represents 100 units)
• Expiration Date: 3 months from today

Step-by-Step Instructions

Enter a Short Futures Contract:

• Action: Sell 1 futures contract on Commodity ABC.
• Futures Price: $500 per unit
• Number of Units: 100
• Total Contract Value: $500 * 100 units = $50,000

Margin Requirements

• Initial Margin: Assume the exchange requires an initial margin of 10%.
• Initial Margin Amount: 10% of $50,000 = $5,000

Profit and Loss Calculation

If Futures Price Falls to $450:

• Short Futures: Obligation to sell at $500 while the market price is $450.
• Profit per Unit: $500 – $450 = $50
• Total Profit: $50 * 100 units = $5,000

If Futures Price Rises to $550:

• Short Futures: Obligation to sell at $500 while the market price is $550.
• Loss per Unit: $550 – $500 = $50
• Total Loss: $50 * 100 units = $5,000