Tue Mar 27, 2007: Synthetic Shorts Using Options (AMZN)

"Sorry, there are no shares of that stock available to sell short now."

Have you ever heard that from your broker?

Well, with options, you can always sell the stock short. Simply sell a call option and buy a put option with the same strike price. You've just created a synthetic short position that will have the same profit/loss return by expiration day that a short stock position would have had.

For example, with the stock currently at $39.37 per share (hey, that's the number of inches per meter!) you could sell an AMZN May 40 call option for $195.

You can buy a May 40 put option for about $230.

Chart of AMZN stock

The income from selling the call approximately offsets the cost of buying the put. (Make a note here that your put is in the money by an "intrinsic value" of $63 so your "premium" cost for buying the put is $230 - $63 = $167 which is $28 less than the premium you received of $195.)

Let's consider what would happen if the stock stayed unchanged by expiration Friday May 18th. The call would expire worthless and you could sell the put for about $63. So you'd just about break even, the same result as if you had sold the actual stock short and the price didn't change. In fact your return would be +195 -230 +63 = $28 profit (ignoring commissions and slippage).

What if the stock went up by $10 per share, to 49.37? Your put would expire worthless for a $230 loss and you'd have to buy the call back for about $937 but you'd get to keep your original income of $195 from selling it. So your total loss would be +195 -230 -937 = -972. That's $28 better than the $1,000 loss you would have had by selling the stock short.

What if the stock went down by $10 per share, to 29.37? The call would expire worthless and you could sell your put for about $1,063. So your total profit would be +195 -230 +1063 = 1,028. Again, that's $28 better than the $1,000 gain you would have had by selling the stock short.

Thus we've seen that you can easily create a synthetic short stock position by selling a call and buying a put at the same strike price.

Consult your investment advisor about margin requirements, risk of being assigned on a naked call that is in the money, and other risks of this strategy.

Until next time, best of luck with your option investments!