From pretty much the beginning of my career in the markets, I understood the concept of short selling stock. You do it because you think price is heading lower, but the mechanics of it look like this:
You borrow shares from another customer at your clearing firm (you don’t know who, and they don’t know it has been borrowed) and you go out and sell those shares on the open market with the promise to buy back or replace them. That makes the other customer whole. Because you’re on the hook for those shares, your position reflects it (ex: -500 shares).
Another aspect of it is that (theoretically) at some point, you may be required to cover that short in order to replace the shares you’ve borrowed. Your broker could call you and notify you to buy back those shares, in which case you’re given a deadline to meet. If you don’t meet the deadline with an order of your own, your broker will do it for you.
Short inventory varies not only from firm to firm, but even by moment to moment. Shares might be available in the morning to borrow for selling short, but unavailable even later on that same day. Or vice-versa. It could be the size of the firm you’re trading with, it could be the popularity of the stock, it could be the price action, or something else – there are just so many variables which affect this.
For as many times as I’ve held overnight short positions, I had never before gotten that phone call – until recently. I was contacted by my broker and informed by phone that I was required to buy back some of the shares I was short. The short stock position I had was actually a by-product of an option assignment, as I had been naked short some calls which became in-the-money (ITM) when price moved above that level at expiration. I already knew the stock had been hard to borrow (for shorting), but had planned to ride out the stock to make my exit. Instead, I was told I needed to cover 400 shares of the 1000 I was short, and that I needed to do it within the next few hours.
Due to my belief that this particular ETF was going to at least pull back from some very extended conditions, I was comfortable being short 1000 shares of it. However, I was a little miffed at the notion of closing out part of the position, even though I understood that the broker was simply doing their part and following the rules. I can appreciate that, so I didn’t give him a hard time. Instead, my solution required some thinking outside the box to come up with another way to be short to the same extent, even though the stock was hard to borrow.
(When you start blending stock and option discussion, it can get tricky. So if that’s not your style, this will likely make more sense to you later. Read this post again if you have to until you get it!)
The measure for me couldn’t be about shares, since I had covered 400 of the 1000 I was short, so it had to hinge on my position Delta.
Owning 1 share of stock gives you 1 delta. Therefore, being short 1000 shares is the equivalent of -1000 deltas. Having come into the day -1000 deltas and then covering 400 shares left me only -600 deltas, so I wanted to get short 400 more deltas after covering the 400 shares of stock.
Enter the synthetic short.
The way around the hard-to-borrow situation was to put on a synthetic short position, which is the combination of a long ITM put option and short OTM call option where your delta of the long put and short call combination equates to around -100.
In this case, I went out 9 months, bought an ITM put (3 strikes) with a delta of -57 and sold an equivalent number of OTM calls (same strike and expiration) with a delta of -41. That gave me -98 deltas per contract, so I did it 4 times. This effectively made up the -400 deltas and brought my overall position back in-line with the -1000 deltas I began the day with ehyma7y.
Synthetic long positions can be done in an IRA since the short put is bullish, it would just be cash-secured. A synthetic short position would need to be done in a margin account, as naked short calls are not allowed in an IRA.
One other note is that when putting on synthetic short or long positions, selecting an expiration several months out means you might pay a little more, but you’ll be less affected by the time decay in the near term.
Therefore, if your intention is to be in the position for let’s say, a few weeks, then paying for several months worth of exposure will still be a good idea. That way, if you’re in it longer than you think, there will be less time decay of the long option you’re buying. It will also help to eliminate the need to extend your duration by rolling, which you would need to do if you run out of time.