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A Synthetic Shorts Primer
Board: The BMW Method

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By RGAnthony
June 20, 2007

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BMWm Options (5.2) Synthetic Shorts.

Last post is here http://boards.fool.com/Message.asp?mid=25578576 and covers (5.0) Combinations and (5.1) Synthetic Longs.

The Basics can be found here if you want to revisit terms:
http://boards.fool.com/Message.asp?mid=25420594
http://boards.fool.com/Message.asp?mid=25420607

5.2--Synthetic Shorts.

The synthetic short is the inverse of the synthetic long. In this case you are setting up a position that will simulate the underlying stock, just like the long; however, your view is the stock is overpriced.

Strategy description: To create a synthetic short you sell (write) a call and buy a put, both ATM, the combination closely duplicates the underlying stock performance. The combined delta of the two positions, which will be approximately 1, should make the position emulate the movement of the underlying stock.

Outlook: You have to be long term bearish, and I would only recommend using LEAPS to establish a synthetic short position. This gives you some time for the position to work in your favor.

Risk: Risks are magnified and a synthetic short has too much risk!! When a momentum bug bites a stock it can stay up longer than I can stay solvent. I do not use this in my BMWm portfolio.

Accounts: Can only be used in a Taxable account.

Advantages: The call leg you write helps pay for the put leg you buy. Leverage is greater than the underlying stock.

Disadvantages: If the stock goes against your view then you have two legs of your position working against you. The downside risk is leveraged and magnified. If you are using synthetic shorts, it is prudent to keep a close eye on the position.

BMW application/Tactical Approach: As I have stated, I do not recommend this approach. However, for this learning exercise let's move through an example. You must be bearish on the stock. Use the longest LEAPS available to give yourself some time for your outlook to play out and keep a close eye on your position.

I just looked at Mike's 30-year charts and Aetna (AET) seems overpriced (http://invest.kleinnet.com/bmw1/statsall/AET.html). It is June 16, 2007 and AET closed at $50.23. Here is the Jan 09 options chain:


 

 Jan 17 2009 Calls | 581 Days to Expiration   
 
                                         
Symbol         Bid            Ask            Stike
+VLCAF        22.80          23.40           30.00
+VLCAH        15.00          15.40           40.00
+VLCAJ         8.40           8.80           50.00
+VLCAK         5.90           6.40           55.00
+VLCAL         4.00           4.30           60.00
+VLCAM         2.60           2.85           65.00

        
Jan 17 2009 Puts | 581 Days to Expiration                                           
                                                     
Symbol         Bid            Ask            Stike
+VLCMF         0.50           0.65           30.00
+VLCMH         1.80           2.00           40.00
+VLCMJ         4.80           5.10           50.00
+VLCMK         7.30           7.60           55.00
+VLCML        10.50          10.90           60.00
+VLCMM        14.60          15.10           65.00 


Example: Set up a synthetic short. Write 10 call contracts AET Jan 09 $50 (VLCAJ) for $8.40 and buy 10 put contracts AET Jan 09 $50 (VLCMJ) for $5.10. The net credit for this synthetic short position is $3,300 ($8.40 - $5.10 * 1000). The delta of the overall position should equal 1. In this case the delta is 1.00 (call delta 0.67 - put delta (-0.33)). The current volatility is higher than the historical volatility so anticipate significant stock movement. Let's look at the two scenarios where AET is <$50 and >$50.

1. AET <$50: Suppose AET is selling for $45 several months down the road. What is the effect on our synthetic short position?

10 Jan 09 $50 calls are worth $2 (all time value) or a total of $2,000.
10 Jan 09 $50 puts are selling for $7 ($5 intrinsic plus $2 time value) or a total of $7,000.

As you can see, both legs of your position moved in your favor and you are up $8,300 (-$2,000 + $7,000 + $3,300). Life is good. Unless you are still very bearish on the underlying this would be a great time to close or modify the position. Closing it is obvious--you made money. Modifying it could include simply closing the short call and/or converting to a bear put spread. Converting to a bear put spread removes the margin requirements; thereby freeing your capital to enter new positions. If you can sell the lower priced put (to complete the spread) for enough to result in a net credit after buying back the call you'll have taken money off the table and own a put spread essentially free--you're using other people's money--my favorite way to play!

2. AET >$50: The stock is selling for $55.

10 Jan 09 $50 calls are selling for $7 ($5 intrinsic plus $2 time value)
10 Jan 09 $50 puts are selling for $2 (all time value)

This time you are down $1,700 (-$7,000 + $2,000 + $3,300). Both legs moved against you so be careful.

You can see if your outlook on the stock is wrong then the position can cause you all kinds of problems due to leverage. Both the synthetic long and synthetic short are highly leveraged positions and you are taking on a lot of risk. One method to reduce your risk would be by using ITM, ATM or OTM legs.

Purchasing an ATM put and writing an OTM call would reduce risk.

Enhancement and Repair: For both enhancement and repair, you can treat each leg as a separate position and review the enhancement and repair for each respectively.

For the put leg, review (4.2) Buying LEAPS Puts. It can be found here:
http://boards.fool.com/Message.asp?mid=25500968

For the call leg, review (3.4) Writing LEAPS Calls. It can be found here:
http://boards.fool.com/Message.asp?mid=25464201.
Since this is not a recommended action there is no discussion of enhancement / repair; however, for actions you could take to repair a short call position see (3.3) Writing short-term Calls (covered and uncovered). It can be found here;
http://boards.fool.com/Message.asp?mid=25456384.

Conclusions. You need to very careful as this is a highly leveraged position (have I said that enough times?). If your outlook plays out all is well. If your outlook does not play out you are taking on the same risk as writing naked calls. If you are going to do that please go back and read 3.3 Writing short-term Calls (covered and uncovered) and 3.4 Writing LEAPS Calls (covered and uncovered). Good luck.

Cheers,
Gary

PS Next in the series--
BMWm Options (5.3) Selling stock positions using Options .


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