Synthetic Shorts and Put-Call Parity

Follow me along this twisted path for a moment.  We all know that a key catalyst for getting a meme stock moving can be a short squeeze.  Shares that are shorted must be borrowed, and in stocks with a high short interest, the cost of that borrow can be quite expensive.  If the stock stalls because the short squeeze peters out, it is logical to look for other culprits.  The latest seems to be synthetic shorts. 

The word “synthetic” has negative conotations.  We all want something natural, organic, or real.  That said, the concept of shorting stock already has negative connotations for many.  The natural order of things is for investors to buy stocks as an investment.  Selling short, which utilizes shares that the seller doesn’t even own (hence, borrowed), flips that idea on its head. 

Shorting and stock borrowing can be tricky concepts to understand, even for market veterans.  I recommend that curious readers listen to an IBKR Podcast entitled “Demystifying Stock Lending”.  It features a discussion with our North American Stock Lending manager that explains many of the nuts and bolts of short selling, including its role in the meme stock craze of 2021. 

One topic that came up in the podcast was “naked” shorting.  This occurs when someone sells stock short without having properly borrowed the shares.  While I always doubted that the practice was as widespread as its loudest opponents claimed, it was indeed unethical, often abusive, and problematic.  In January 2005, the SEC adopted Reg SHO to address the matter.  It is widely believed to have been successful in its aims.  (The SEC website explains Reg SHO in detail.)

Thus, if naked shorting is bad, so must be synthetic shorting, right?  Umm, no.  A synthetic short is legal and transparent, properly utilizing the listed options market.  To understand that, one also needs to understand a fundamental options market concept: put/call parity.  At its most basic, the equation is this:

Call Price + Strike Price = Forward Price + Put Price

It is important to keep in mind that we are using the forward price of the stock, not the current price.  In a positive rate environment, the forward value of an asset is typically higher than the current, or spot, price.  If the stock is hard to borrow, that forward value can be quite a bit lower than the spot price, reflecting the cost to borrow the shares.  

Using a bit of simple algebra, we see how one can replicate the forward value of the stock:

  Forward Price – Strike Price = Call Price – Put Price

In other words, if a trader buys a call and sells a put with the same strike and expiration he creates a position that matches that of the forward price of the stock less the striking price.   That is called a “synthetic”.  Using options, the trader now mirrors the movements of the underlying stock or future one-for-one.  This is done routinely, when traders have a different view about the interest rate or dividend assumptions that underlie a stock. 

Flip that trade around, selling calls and buying puts, and you create a synthetic short.  Again, you move one-for-one with the price of the underlying stock, but inversely.  The trade is done on an options exchange, so the volume and open interest are disclosed, not hidden in a nefarious manner.

Also, someone is on the other side of that trade, meaning that an identical synthetic long is created for every synthetic short.  Now, the holder of the synthetic long may want to hedge his exposure by shorting against the synthetic shares that were just created, but the hedger needs to locate and borrow the shares.  Either someone has to go out and add to the shorts that are liable to be squeezed, or someone is enough of a believer to take the long side of the trade.  Neither of those should offer too much concern.

It is understandable why the idea of synthetic shorting sounds devious or nefarious.  But it’s not.  Devotees of a particular stock might not love the idea of someone using the options market to bet against their holdings, but that a feature of markets.  If you think the stock is going up, then buy it; if not, then sell it.  Over time, the market will sort out who is right and wrong.  But as long as that activity is done within established securities regulations, it shouldn’t matter in what form those views are expressed.