Overriding Short-Selling Restrictions

Sometimes, the prospects for a stock are not very good. You might want to open a short position on a stock when the price is too high relative to earnings, when economic prospects deteriorate, or simply when you believe a stock will suffer some selling pressure. But the availability of short selling may be limited for many reasons, making it difficult to proceed with a stock strategy.

Fortunately, you can mirror almost any payoff you want with the use of options. Instead of selling a stock you can arrange for a synthetic short sale. Last week, we showed how you can mirror the performance of a long stock position with just two options. Today, we invert that strategy. While a synthetic long position is built with a long call and a short put, a synthetic short position is built with a short call and a long put.

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The use of options strategy can help you surpass the difficulties that sometimes exist around short selling. Options are more tax- efficient and simplify the investment process. But, unlike the synthetic long , you don’t receive the inflow from short selling. Shorting a stock involves receiving an initial inflow, which you can use for other investments. When building the synthetic short position, you will probably end up with an initial outflow, even if it’s very small. That’s because the premium paid in the long put is mostly offset by the premium received from the shorted call.

A synthetic short, or short combination, involves buying a put option while selling a call option both with the same strike price (usually near-the-money) and the same maturity date. If you don’t close your position before maturity, you will be forced to short the stock at maturity.

Let’s think about the same example we used last week: Suppose Google is trading at $1,217.50. If you plan to sell 100 shares, you will get an initial inflow of $121,750. If you build the synthetic strategy instead, you need to purchase a put option with a strike of $1,217.50 and short a call option with the same strike. At maturity, you will exercise the put if the price of the stock is below $1,217.50. If the price is above that level, the call holder would exercise his option to buy the stock, which would force you to short the stock.

The strategy then mirrors the payoffs of a short sale with some small differences due to the option premiums. Let’s consider what occurs at maturity with some example numbers. Assume a call expiring in one month is currently available to sell at $29.10, while a put is available to buy at $31.20. If you sell 100 shares, you receive $121,750 up front. If instead you build the options strategy, you need to spend $210. The final payoffs deriving from the options strategy will be slightly lower than the payoffs deriving from holding the stock. For example, suppose that Google shares decline 5 percent to $1,156.63. Your gain for holding the stock is $60,900 ($60.9 x 100). In terms of the synthetic position, the gain would be $58,800.

The synthetic short is a risky strategy, carrying unlimited risk with limited upside potential. Therefore, you should always approach a synthetic short very carefully. However, it’s the same as a short sale, which has the same risk structure.

In addition, the equivalent to shorting stock is to buy a put, short the call, and ask for a loan. It is equal to the difference between the stock price and the net premium paid for the options. Only, that way, you pocket some upfront money as in the case of a short sale of stock.

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