Dawn Pennington

Synthetic Call Options Similar to Real Deal

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As expected, if the opposite of a long call is a short one, then the execution of the synthetic short call is the exact opposite of the synthetic long. Thus, you would write (or short) a put in a 1-to-1 ratio as you would short the stock. Again, for each put option contract you write, you would also short 100 shares.

Just like the "real thing," the losses that can be associated with short calls can be unlimited, particularly because you are doubly short -- both with the puts as well as the underlying stock.

But before you ask why on earth anyone would put themselves in a situation where they might not only have the short puts assigned to them (that is, the long put holder might choose to put their long stock to you) but also perhaps be forced to "cover" the short stock position at a higher price, keep in mind that synthetic positions are geared toward early exercise. That is, if the position becomes profitable, there's no reason why you have to hold it any longer than you need to in order to bank some quick gains.

This strategy works with stock options, which have American-style expiration. This means that they offer the benefit of early exercise, whereas index options have European-style exercise. That is, they can only be exercised at the end of their expiration cycle.

The goal with any short call, synthetic or otherwise, is for it to finish out-of-the-money. When you short an option, you collect premium upfront and you aspire to keep that money. When you short stock, you want to "sell high and buy low" -- that is, short it at a higher price than you expect it to end up at. For instance, you sell to open the XYZ Oct 40 Put if you think the stock will trade down to $40 or lower before October options expiration.

If the stock falls to $40, the stock you shorted at $45 per share, for example, you've made $5 per share. When the stock drops, the short put finishes out-of-the-money and you keep that premium.

If the shares go up, not only are you at risk of buying shares at or above the price at which you shorted them to cover the short stock position, but the synthetic short call strategy functions the same as a "real" short call position.

If the shares go up in value and you're betting on the stock staying at or below $45 and the stock trades up to $50, losses can be unlimited because a stock can keep trading up, up and away.

If you're going to do a synthetic short call strategy, stay away from the Apples (AAPL) and Googles (GOOG) and other companies that seem to always be coming out with the newest and "coolest" products. Rather, stick with more of a stalwart company that's either stuck in neutral or whose industry might be falling out of favor on Wall Street -- one whose stock price isn't in jeopardy of skyrocketing while you're invested in a synthetic or an actual short call.

Big risks can provide big payoffs, but when it comes to being short, a long put option is always the safest way to go!