A Low-Risk Option Strategy: Synthetic Short Stock

The dilemma of the long stock position is unending downside risk. This is where options serve their best purpose: as tools for portfolio management.

Rather than use only as speculative and high-risk market plays, strategies like the synthetic short stock position protect against downside loss and, unlike the better-known covered call, offer a practical alternative to selling and taking profits.

Its construction has three parts. For every 100 shares held long, you open a long put and a short call at the same strike. If this position is opened at or near the basis in stock, it is a senseless position. If the stock moves up, the call is assigned and your stock called away. If the stock moves down, you exercise your put and sell at the strike. In neither event is there an opportunity for profit.

Now look at the synthetic short stock in another way.

Let's assume you bought stock well below current market value and you have two issues in mind. First, you are willing to sell now, but you're not sure if that is a good move. Second, you are tempted to sell because the stock price could easily decline and you would lose part of your paper profits. In this situation, the synthetic short stock makes sense.

For example, you bought 100 shares of Altria (NYSE: MO) a year ago at $25 per share. Today the stock is worth $29.50 (based on February 2012 price range). You have an 18% paper profit and you're tempted to sell and take it. But MO is paying above 5.5% dividend and you would prefer to keep earning it.

If you are willing to sell at $29 to avoid the threat of loss, and you allow ant to protect against the downside, a synthetic short stock strategy will work for you.

The March 2012 29 call is worth 0.70 and the 29 put is worth 0.42. Selling the call and buying the put creates a net credit of 0.28, but trading costs are likely to offset most of that. At the same time, the paper profit is protected at the 29 strike. If the stock value falls below that, the put's intrinsic value will offset the loss.

You can either sell the put to take the profit, or exercise the put and sell shares at $29 per share, this setting up a four-point profit. The put costs nothing because the value of the short call offsets it.

If the stock price rises above 29, the call will be exercised. To avoid exercise you can close the position or roll forward. So you achieve a degree of protection against downside movement while accepting exercise (or avoiding it) on the upside.

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