Synthetic Long Put

This strategy combines a long Call and a short stock position. Its payoff profile is equivalent to a long Put’s characteristics. The strategy profits if the stock price moves lower–the more dramatically, the better.  The time horizon is limited to the life of the option.

Market Outlook

Bearish to very bearish sentiment among market participants.

When to Use

An investor often employs a synthetic long put strategy to profit from the severe fall in the underlying’s price.

Profit & Loss Chart

Benefit

A Synthetic Long Put is often established as an adjustment to what was originally simply a Short Stock position. There is one possible advantage over a Long Put: in the event of an extended trading halt, the Synthetic Long Put strategy does not require any action since the stock was sold when the strategy was implemented.  However, as with any short sale, there is always a risk of being forced to return the stock.

Risk & Reward

Maximum Profit: Substantial
Maximum Loss: Limited

The maximum gain is limited but quite substantial. The best that can happen is for the stock to become worthless.  In that case, the investor could buy the stock for zero to close out the short stock position. The total profit, however, would be reduced by the premium paid for the Call option, which expired worthless.

The maximum loss is limited. The worst that can happen is for the stock price to be above the strike price at expiration, in which case the short stock position can be closed out by exercising the Call option.  The loss would be the selling price of the stock (where it was sold short), less the purchase price of the stock (the strike price), less the premium paid for the Call option.

Break Even Point

Initial Short Sale Price – Premium Paid

Volatility Changes

Increase In Volatility: Positive Effect
Decrease In Volatility: Effects Vary

Time Decay (Theta)

Negative Effect

The passage of time will have a negative impact on this strategy, all other things being equal.  As expiration approaches, the Call’s resale value tends to converge on its intrinsic value, which for out-of-the-money options is zero. Also, the sooner the Call expires, the sooner it ceases to offer protection for the short stock position in the event of an unexpected rally.