Short Combo
The Short Combo strategy, often called a synthetic short stock, is an options trading strategy that replicates the risk and reward profile of selling a stock short. The strategy is done by selling a call option and buying a put option with the same expiration date and usually the same strike price. It is suited for investors who expect a dramatic drop in the price of the underlying stock.
The Short Combo Setup
You are bearish on ABC Corporation, which is currently trading at $100 per share. To place the short combo, you might:
- Sell a call option having a strike price of $100 and collect the premium of $4 per share.
- Buy a put option with the same strike price of $100 but pay a premium of $4 per share.
Ideally, this arrangement does not incur any net cost for entering the trade, except for transaction fees, since the premium received from the call offsets the cost of buying the put.
This strategy is well-suited for investors who are bearish on a particular stock and are looking for a way to profit from its potential decline without actually shorting the stock. It’s appropriate for those who believe the stock will drop significantly before the options expire.
When you sell a call, you commit to selling the stock at the strike price when the option is exercised, thereby replicating the risk of short selling. Buying a put entitles you to sell the stock at the strike price, thus allowing you to benefit if the stock price declines below this level.
The breakeven point for a short combo is the strike price of the options used. Since the initial setup is designed to be cost-neutral, the stock price must move below the strike price by the expiration for the position to profit, similar to short selling.
The sweet spot for this strategy is when the stock price falls well below the strike price of the call and put options. The lower the stock price goes, the greater the potential profit.
The maximum profit for a short combo is limited to the strike price minus zero (assuming a stock can’t go below $0), which would occur if the underlying stock went to zero.
The maximum loss is theoretically unlimited since the stock price can go up indefinitely. The more the stock price rises, especially above the strike price of the call, the more your losses will run since you will have to deliver the stock at the strike price when the call is exercised.
The primary risk with a short combo arises if the stock price increases. This strategy has similar upside risks to short selling the stock, where potential losses can be extensive if the stock price rallies.
Time decay (theta) affects this strategy both negatively and positively. The value of the short call position benefits from time decay since it helps the sold call option lose value more quickly, which is beneficial if the stock price is below the strike. However, the long put position loses value due to time decay, which is not desirable if the stock price doesn’t move as expected.
Changes in implied volatility may significantly affect this strategy. The cost of the put increases with volatility; such an increase can offset the initial cost of establishing the strategy through its balance by the value of the call when it is unbalanced by the latter. Conversely, a decline in volatility generally decreases the value of the put, and reduces the profitability of the strategy if the stock declines.
The short combo is a tactical strategy that serves as a very effective way to make money should a stock start to decline, without being obligated to borrow to short sell. Like actual short selling, though, there are huge risks associated with the strategy, particularly in instances where such a stock or stocks happen to move in the wrong direction.