When to use: Short Synthetic Option Strategy is used when the investor is bearish on the stock in the near future (i.e. the investor expects the stock to fall in the near future).
How it works: In a short synthetic option strategy you sell 1 call option and buy 1 put option of the same underlying stock with the same expiry date and the same strike price. You believe that the market will be bearish until expiry.
For example: On 29th August 2013, the share of Indian Hotels (IHCL) was trading at Rs. 45.10, you decide to sell 1 call option with a strike price of Rs. 45.00 at a premium of Rs. 3.00. At the same time you buy a put option with a strike price of Rs. 45.00 at a premium of Rs. 2.15.
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Risk/Reward: In the short synthetic option strategy, your maximum risk will be unlimited and the maximum reward/profit which you stand to make from this trade will also be unlimited.
In the short synthetic strategy, loss will incur when the price of the underlying stock becomes higher than the strike price of the short call option, i.e. when the underlying stock price moves upward. Profit will be made when the price of the underlying stock is less than the strike price of the long put option, i.e. when the underlying stock price moves down.
For short call option: If the price of Indian Hotel share stays below Rs. 45.00 (i.e. the strike price of the short call option) until expiry, you will retain the entire premium amount (i.e. Rs. 3.00). If however the price rises above Rs. 45.00, the buyer of the call option may exercise his option and make a profit based on how far above Rs. 45.00 does the stock price rise. From the perspective of the seller of the call (you), you will start suffering a loss once the stock price rises above Rs. 48.00 (i.e. strike price + premium received).
For long put option: If the price of the share falls below Rs. 45.00 (i.e. the strike price of the long put option) until expiry, you can exercise your option but the price of the stock must fall below Rs. 42.85 (i.e. strike price minus the premium paid), for you to exercise your option and make a profit. If however, the stock price does not fall below Rs. 45.00 (i.e. the strike price) until the date of the expiry, you will not be able to exercise the option and the option will lapse worthless in which case you will lose the option premium of Rs. 2.15.
The table below shows the net payoff of the short synthetic option strategy at different spot prices upon expiry:
How to use the Short Synthetic Option Strategy Excel calculator
Just enter your expected spot price on expiry, option strike price and the amount of premium, to estimate your net pay-off from the Short Synthetic Option Strategy.
Note: The example and calculations are based assuming a single share though in reality options are based on lots of many shares. For example Indian Hotels option contract is for 4,000 shares. Accordingly the net premium received will be Rs 3,400 for 2 lots (i.e. 0.85*4,000) in our example.
Also Note: Unlike the buyer of an option who only pays the premium to buy the option, the seller of an option must deposit a margin amount with the exchange. This is because he takes an unlimited risk as the stock price may rise to any level. In case the price rises sharply above the strike price, the exchange utilises the margin amount to make good the profit which the option buyer makes. The amount of margin is decided by the exchange and it typically ranges from 15 % to 60 % based on the volatility in the underlying stock and market conditions. In the above example, as a seller of call option, you will have to deposit a margin of Rs. 25,830 (i.e. Strike price * Lot size * 16.85%) for selling/writing a lot of Indian Hotels call option. Note that the total value of your outstanding position in this case will be Rs. 1,80,000 (i.e. strike price * lot size).
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