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Synthetic Put

Synthetic Put

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Basics Concepts – Synthetic Put

Basics Concepts – Synthetic Put

Description – Synthetic Put

  • Basically, we buy the stock, but we insure against a downturn by buying an ATM or slightly OTM (lower strike) put.
  • The net effect is that of creating the same shape as a standard long call but with the same leverage as buying the stock.
  • We’re capping our downside in case the stock unexpectedly drops through our stop loss.
  • The long put will increase in value if the stock collapses, thereby countering the loss in value of the long stock position.
  • The risk profile therefore contains a capped downside because of the long put and an uncapped upside because of the long stock position.
  • The level of insurance depends on where you place the put strike and the cost of the put.
  • Buy the stock.
  • Buy ATM (or OTM) puts.
  • The closer the put strike is to the price you bought the stock for, the better insurance you’ll have if the stock falls.
  • However, the better insurance you have in that regard, the more it will cost you.
  • Notice that you have created the risk profile of a call option (but you have paid a lot more for it).
  • What you are doing is capping your downside risk by buying the put option, having bought the stock.
Description – Synthetic Put

Steps to Trading a Synthetic Put

Steps In

  • Try to ensure that the trend is upward and identify a clear area of Support.

Steps Out

  • Manage your position according to the rules defined in your Trading Plan.
  • If the stock falls, then you may need to unravel the entire trade because the stock is behaving contrary to your expectations.
  • Remember to buy more time than you strictly require so that you avoid the final month of time decay.
  • If the stock falls below your stop loss, then either sell the stock and keep the put or unravel the entire position.

Context - Synthetic Put

Outlook

  • With Synthetic Puts, your outlook is conservatively bullish. This is a low-risk strategy.

Rationale

  • To buy a stock for the medium or long term with the aim of underwriting your downside in the meantime.
  • If the stock rises, you will make profit.
  • If the stock falls, you will lose money, but your losses will be capped at the level of the put strike price.

Net Position

  • This is a net debit trade because you’re buying both the stock and the put.
  • Your maximum risk is limited if the stock falls.

Effect of Time Decay

  • Time decay is harmful to the value of the put you bought.

Appropriate Time Period to Trade

  • Buy the puts with as long a time to expiration as you need the insurance . You can avoid the worst effects of time decay.

Breakeven = [Strike price + put premium + stock price – put strike price]

Exiting the Trade - Synthetic Put

Exiting the Position

  • If the share falls below the strike price, you will make a limited loss.
  • If the share rises above the strike price plus the put premium you paid, you will make a profit. For any exit, you can either sell the stock or sell the put, or both.
  • If the share rises and you believe that it may fall afterwards, then you can just sell the stock and wait for the put to regain some of its value before selling that, too.

Mitigating a Loss

  • You have already mitigated your losses by buying the puts to insure your long stock position.

Advantages and Disadvantages

Advantages

  • Buying the put insures your long stock against a catastrophic decline
  • Capping your downside risk more effectively than just a stop loss on the stock alone, particularly in the event of a gap down.
  • Upside is uncapped.

Disadvantages

  • The rate of leverage is much slower than simply buying a call.
  • This can be considered expensive because you have to buy the stock and the put.

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