Synthetic Stock Positions
It is possible for traders to synthesize a long or short stock position by trading particular options in place of laying out cash to buy or short shares. Having this ability gives option traders the flexibility to pursue several trading strategies depending on the conditions of the market.
To create a synthetic long position using options, the most direct way is to buy a call option and sell a put option on the same strike for the same expiration. This is effectively the same risk exposure as buying shares of the stock. If the stock price goes up, it will return a positive payout. If the stock price drops, it will return a loss.
The same can be said for putting on a short position using options. However, to put on a short position, a trader would instead buy the put and sell the call on the same strike for an expiration.
Put-Call Parity
Most of the time, option markets are fluid enough that they will correct any brief advantageous conditions, due to a relationship called the put-call parity. Put-call parity maintains that the value of a combination of a long call option and a short put option is the same as the value of holding the underlying stock going forward. Without this parity, arbitrage opportunities would exist, so when they open up for short periods of time, they are usually corrected by changes in the option premium. This relationship can affect how traders balance their portfolios between stocks and options.
Synthetic Short vs. Shorting Stock
In some cases, putting on a synthetic short position is more cost-effective than simply shorting shares of the stock. To short shares of the underlying stock, traders must borrow the stock from a lender. This can be problematic because it depends on the trader finding a lender to borrow the stock from, and in some cases having to pay the lender an aggressive borrowing rate. Additionally, short positions on stock are susceptible to Reg-SHO, a federal regulation that can sometimes force traders to cover (buy back) their short stock positions.
In scenarios where there is a limited availability of the stock, lenders might charge an increased borrowing rate to traders -- meaning the trader would have to pay the lender a higher amount of money over time just for the ability to short the stock. This is referred to as being hard-to-borrow.
If this is the case, it could be more cost-effective to synthesize a short position using options. However, option markets are typically very sensitive to changes in the markets of their underlying stocks. When a stock becomes hard-to-borrow, option premiums will go up in put markets and go down in call markets -- effectively limiting the advantage gained by synthesizing the short position.
You can find more about hard-to-borrow rate and other option pricing factors by reading our section on Cost of Carry, but let's take a look at some of the conditions that might exist for traders to execute some of these synthetic positions.
Conversion
A common strategy used by option traders who are establishing a synthetic short position is the conversion. A conversion is done by buying the put, selling the call on the same option strike, and buying the underlying stock -- a step we didn't discuss above. Effectively, this eliminates the unlimited risk (and unlimited gain) of simply putting on a short position. However, there are many conditions where it would be advantageous to do this.
Future stock dividends are priced into the option market, but in many cases, traders are simply speculating on the amount of the dividend based on past dividends or information released by the stock issuer or related corporation. If a trader believes that the market is pricing in a dividend that is too low, they could execute a conversion. The conversion eliminates the risk of a price move -- even if it goes up 20% or down 20%, the risk of the trader is limited. If the dividend is paid for more than what the market was implying, the dividend that they receive by owning shares of the stock will be greater than the premium that they paid on the options at the time of the trade.
A similar strategy is applied when a trader might believe that a stock will become hard-to-borrow in the future. As we discussed earlier, increased borrowing rates will raise put premiums and lower call premiums, so owning puts and selling calls would be an advantageous position in that scenario.
Reversal
The opposite of a conversion is a reversal, when a trader would buy the call, sell the put on the same option strike, and sell the underlying stock. Similar factors go into applying this type of position, only done in the reverse of the concepts we discussed above. Like with a conversion, a reversal alleviates the unlimited risk of stock price movement.
When a trader feels that the options market is pricing in a dividend that is higher than they expect will be paid, it might be a good time to execute a reversal. Selling the put includes receiving a certain amount of premium priced in for the future dividend. However, the trader will have to pay the dividend out on the short stock at the time of the dividend, so to make this worthwhile, they will need to receive more from the current market than what they will have to pay in the future. If a trader believes that a dividend could be suspended or discontinued altogether, and the market is not reflecting that, executing a reversal could be a beneficial strategy.
Additionally, if a stock is currently hard-to-borrow and the options market is pricing that into the put premium, but a trader believes the stock will become more widely available and these hard-to-borrow rates will go away in the future, then they could execute a reversal. If the hard-to-borrow rates decrease in the future, call premiums will go back up and put premiums will go down, to the benefit of this strategy.
