Share Market

A ‘’synthetic’’ short sale is a combined option strategy that acts just like shorting a share. Options are a form of a derivative instrument (the asset which undertakes its value from the underlying asset) provides the holder of the option the right but not the obligation to exercise the contract.

An option consists of two types, the call option and a put option. An option which conveys the right to buy the asset is called the call option while the option which conveys the right to sell the asset is called put option. The reference price at which the underlying asset is traded is called the strike price or the exercise price while the process of executing the option and trading the underlying at the said price is called as exercising.

This concept comprises of a short call and a long put opened at the same time, using the same strike and expiration. Let`s understand the concept with the help of an example:

Consider John purchased a long 50-strike call and a short 50 strike put. This will result in purchasing the underlying asset for 50 at exercise or expiration. If the underlying asset is greater than 50 then the call option would be in the money and would be exercised; if the underlying asset is less than 50, then the short put position would be executed, thus resulting in the forced buying of the underlying asset.

This strategy is more often used against shorting a stock, since shorting is the one which many avoid. In sorting, one borrows a stock from a brokerage firm and asks the brokerage firm to sell the share of the company at a higher price. The trader then expects the share of company to fall. (He in turn buys the share of the company when the price drops). However, in the bargain one has to ensure a proper margin and interest on the borrowed share. The risk in turn arises when the share price rises resulting in the increase in the margin requirements and the loss of money.

There two major advantages for opting a synthetic position. The first one 1) one does not need to borrow the share in order to sell it and 2) the cost of the transaction is low with the short and the long offsetting each other.

From this article we can conclude that while derivatives are known to be a cause of major market scandals, these instruments aren’t really so bad to benefit from during a bearish trade rally.