Question

Synthetic positions are financial positions that mimic another position but use different instruments to do so. A short sale of a stock is a strategy where we borrow shares under the expectation that their prices will drop. If they do, then we buy them back and repay the loan at a profit. In doing so, we are financially obligated for the whole value of the shares which could cost us a large amount of money. A synthetic short sale mimics the short with options but without the large financial cost.

A synthetic short sale is created with a long put and a short call with the same strike price and expiration dates. Bank of America stock is currently trading at $21.71 per share. A May $25 call is trading at $2.75 and a May $25 put is currently trading at $2.25.

1. Evaluate the payoffs of a short sale of BOA and the synthetic short sale at prices of $18, $25 and $28. Don’t forget the premiums on the options in your calculations and that each contract is for 100 shares. Assume your short sale is 100 shares also.
2. Draw a payoff profile for each strategy.
3. Compare the payoffs of each strategy in terms of monetary outlay and payoff at each price.

Answer 1

Note: Number of shares in call and put option contract is 100 shares

Profit/(Loss) at various stock prices using both methods. Actual short selling and synthetic short selling using options