Understanding Options Trading Strategies: Synthetic Put

In this article, we will discuss

• What is a Synthetic Put?
• Setting Up a Synthetic Put
• Key Price Levels in the Synthetic Put
• An Example of the Synthetic Put Strategy
• Options Trading Made Easier with Samco’s Options B.R.O.

Thousands of options trading strategies are available to traders in the F&O segment. Finding the right strategy in any given market condition can be quite a challenge. However, this is easy for smart traders with access to the right tools — like Options B.R.O, an advanced options strategy builder from Samco Securities. Here, you simply need to access this feature on the Samco trading app, enter the details required and find the top strategies for your trade.

However, to choose from the best options strategies for any given market outlook, you must know what different trading strategies entail. In this article, we will discuss one such options-buying strategy — the synthetic put.

What is a Synthetic Put?

A synthetic put is a strategy that combines a short position in the underlying asset’s cash market with a long position in a call option. It is best used in a bearish market. Additionally, it has the advantage of inherent hedging, thanks to the long call. So, it protects you from unexpected upward price movements.

Since the overall outcome of the position resembles that of a long put, it is called a ‘synthetic’ put. Interestingly, this options trading strategy is also known by other names like synthetic long put, protective call and married call. It is best used when you are fairly bearish on a stock or security, but also want to protect your trade against a near-term bullish move in that asset.

Setting Up a Synthetic Put

Setting up a synthetic put is extremely easy. It involves two straightforward trades, as outlined below:

• Trade 1: Shorting the Underlying Asset

Identify the stock that you are bearish about and take a short position in that company. Note that in the cash segment, short positions can only be held intraday. So, you can substitute this trade with a short position in the asset’s futures market. However, in that case, you will also have to be mindful of the margin amount required to open and hold your position.

• Trade 2: The Long Call

In this trade, you purchase an at-the-money (ATM) call option of the stock that you shorted in the cash or futures segment. That short position aligns with your bearish market view. However, if the stock price rises unexpectedly, you need a hedge to protect you from that upside movement. The long call in the synthetic put strategy provides this hedge.

Key Price Levels in the Synthetic Put

You must understand the best and worst-case scenarios before you execute this options-buying strategy. These price levels include the maximum possible gain, maximum potential loss and break-even price points. Let us get into these details, so you can better understand how to analyse this options trading strategy.

• Maximum Loss

The maximum loss in the synthetic put strategy is limited. In the worst-case scenario, the stock price remains above the call option’s strike price, making the short position a loss-making trade. However, you can close your trade by exercising the call option and buying the underlying stock at a favourable price.

The maximum loss from this trade can be summed up in this formula:

Maximum Loss = Short Sale Price of the Stock — Strike Price — Options Premium Paid

• Maximum Gain

If the trade is profitable, the maximum gain is also limited, though it can be significant. The best-case scenario occurs if the price of the stock falls as expected and the option expires worthless, leaving your short position profitable. The lower the stock price falls, the more your profit increases.

The formula for the maximum gain from a synthetic put strategy is:

Maximum Gain = Short Sale Price of the Stock — Lowest Possible Market Price at Expiry (i.e. Zero) — Options Premium Paid

• Break-Even Price

The break-even price is the point at which you end up with a no-profit, no-loss net result. This limit is important because it helps you make a better estimate of how likely an options trading strategy is to turn profitable or loss-making. Some strategies may have two break-even prices.

The synthetic put, however, has just one, as determined by the following formula:

Break-Even Price = Short Sale Price of the Stock — Premium

An Example of the Synthetic Put Strategy

Now that you have seen how the synthetic put strategy is set up and what its key price levels are, let us delve into a practical example of this hedged trade. Since shorting in the cash segment is only allowed for intraday trades, let us use futures instead to take a short position and complement it with a long call trade. This will allow us to create a synthetic put position that mimics the payoff of a long put option.

Consider the following parameters for a company’s stock:

• Current stock price: Rs. 2,500
• 1-month futures price: Rs. 2,520
• Expiry is 30 days from now

To set up the synthetic put strategy, you need to execute the following trades:

• Trade 1: Sell 1 futures contract with a lot size of 500 shares at Rs. 2,520 each

• Trade 2: Buy 5 call option contracts with a lot size of 100 shares each and a strike price of Rs. 2,520 by paying a premium of Rs. 70 per share

Let us see what the initial cost of setting up the trade comes out to be. The total options premium is Rs. 70 per share, and you have purchased 5 options with a lot size of 100 shares each. So, the total premium paid will be Rs. 35,000.

In addition to this, you will also have to pay the margin money required to open a position in the futures market. The actual margin requirement may vary based on broker and market conditions. Always check current margin requirements before trading.

Now, let us examine the outcomes at different possible prices at expiry.

• Scenario 1: The Futures Price Rises to Rs. 2,700

  • Loss on futures position= 500 × (Rs. 2,700 — Rs. 2,520) = Rs. 90,000
  • Profit on call options = 500 × (Rs. 2,700 — Rs. 2,520 — Rs. 70) = Rs. 55,000
  • Net loss = Rs. 90,000 — Rs. 55,000 = Rs. 35,000

• Scenario 2: The Futures Price Falls to Rs. 2,300

  • Profit on futures position = 500 × (Rs. 2,520 — Rs. 2,300) = Rs. 1,10,000
  • Loss on call options (premium paid) = Rs. 35,000 (since the option expires worthless)
  • Net profit = Rs. 1,10,000 — Rs. 35,000 = Rs. 75,000

• Scenario 3: The Futures Price Remains at Rs. 2,520

  • No profit/loss on futures position
  • Loss on call options (premium paid) = Rs. 35,000
  • Net loss = Rs. 35,000

Options Trading Made Easier with Samco’s Options B.R.O.

The synthetic put strategy is only one of the many strategies you can use in the options market. Since it can be difficult to find the right strategy in a dynamic market with rapidly changing prices, you need an agile and advanced tool like Samco’s Options B.R.O. With this advanced strategy builder, you can not only find the most suitable strategy for your market outlook, but you can also execute the trade with just one click from the Samco trading app itself.

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