Learn the difference between synthetic short and shorting the underlying

Last week, we discussed the synthetic long position and its characteristics. A synthetic short position is the exact opposite and yet it warrants a separate discussion. The reason is because a synthetic short position moderates the risk associated with shorting the underlying. In this article, we discuss why this position compares favourably to shorting the underlying.

Time decay factor

You can set up a synthetic short position by going long a put and short a same strike call of the same expiry with the strikes close to the current price of the underlying. With the underlying currently at 17855, we chose the 17800 call and put. The objective is to profit from the short option through decline in its time value and intrinsic value. Recall that last week, we set up a synthetic long position with strikes that was an in-the-money put and an out-the-money call.

You can set up a synthetic short position with the 17800 options for a net credit of 82 points. This is because the short call has intrinsic value whereas the long put has only time value. Note that going long a put will enable the position to generate profits when the underlying declines, just as a short stock would. Likewise, going short a call will lead to losses when the underlying moves up, just as a short stock would.

Suppose the underlying declines 100 points two days after you setup the synthetic short, the position would gain 105 points. On the other hand, if the underlying increases 100 points, the position would lose 94 points.

What happens if the underlying declines 100 points three days before expiry? The synthetic short would gain 119 points. On the other hand, if the underlying increases 100 points, the position would lose only 81 points. This suggests that the position generates more gains than losses for the same change in the underlying price.

What if the underlying were to trade at 17800 when you setup the synthetic short position using the 17800 options? You could set up the position for a net credit of 26 points assuming the same implied volatility as before. If the underlying were to move up or down 100 points two days after, the synthetic position could move up or down 100 points. And if the underlying were to decline 100 points three days before expiry, the synthetic short position could generate a 119-point profit. Whereas if the underlying moved up 100 points, the loss could be 82 points.

Optional reading

The above price behaviour can be explained as follows: A significant proportion of the gains on the synthetic short comes from the short call. That is, when the underlying declines, the loss in both the time value and the intrinsic value on the short call contribute to the position’s profits. When the underlying moves up, the losses are lower because time decay on the long call reduces the one-to-one movement in the call price.

Note that the benefit of time decay is maximum when the underlying declines closer to expiry than earlier. This is because gains from short call due to loss in time value and intrinsic value is more than the loss in time decay on the long put. The time decay is smaller for weekly options during the week preceding expiry. That is when the time decay from the short call is typically offset by the time decay on the long put. Therefore, the synthetic short closely mirrors the underlying when it moves 100 points two days after setting up the position.

The upshot? You could consider a synthetic short instead of shorting the underlying. You should choose strikes closer to the underlying price. Importantly, the short call should have intrinsic value. It will also help if the implied volatility of the short call is higher than that of the long put.

The author offers training programmes for individuals to manage their personal investments

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