A synthetic SHORT position is created by selling an out-of-money CALL and buying an out-of-money PUT.
E.g. Synthetic LONG Position The idea is to use the money collected from selling the PUT to buy the CALL option. You basically create a LONG position fairly much like a Stock position with zero upfront payment. The time-decay on the PUT sold will compensate for the time-decay on the CALL.
E.g. Synthetic SHORT position
25-Mar-09 Wed (expecting UBS price to drop)
Created 30 contracts of synthetic SHORT positions on UBS when the share price was $11.21.
STO 30x UBS-Apr-$12.50-CALL at $0.70 (collected $2,100)
BTO 30x UBS-Apr-$10.00-PUT at $0.70 (paid $2,100)
For Sold leg (i.e. the CALL option), we placed STOP-LOSS order for protection and LIMIT order for Profit-Taking.
If share price at expiry Fri stays within $10 to $12.50, both legs will expire worthless.
If share price drops before expiry, we can make money. If share price is below $10 at expiry, we made money.
If share price increases before expiry, we can lose money. If share price is above $12.50 at expiry, we lose money.
27-Mar-09 Fri (UBS share price dropped as expected)
UBS at $9.91 now. Instead of waiting for the sold CALL position to reach 80% (at $0.14) of max potential profit (at $0.70), we manually closed the CALL position (at $0.25) when profit reached 65% of max potential profit. And we closed the PUT position (at $1.10) as well which is already 57% in profit. Closed the positions because the risk/reward ratio has skewed significantly due to deep in-the-money.
BTC 30x UBS-Apr-$12.50-CALL at $1.10 profited $1,329 (65%)
STC 30x UBS-Apr-$10.00-PUT at $0.25 profited $1,188 (57%)
Total profit $2,517.
One of the main advantage of synthetic position is we are "neutral" to time decay. This can be very useful if we create position with far far out expiry-date.
