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The original was posted on /r/Superstonk by /u/theorico on 2024-10-04 11:46:55+00:00.
This is a follow-up from my previous post.
Recapping, here is the TLDR of the TLDR for that post:
- Finra proposed many improvements in the reporting for Short Interest back in 2021.
- They requested among other things, that Firms would start reporting short interest coming from Synthetic Shorts, which are not covered by current rules (!). Finra requested Firms to comment on their proposal.
- Big Firms rejected the improvements. In their comments to Finra’s proposals they formally admitted that there are many ways to generate synthetics(!), and gave several empty excuses on why it would be much difficult or it would take too much time to make what Finra was requesting.
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Let’s start going a little deeper into Synthetic positions, and in special into the Synthetic Short Stock.
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Synthetic Positions
There are mainly 6 types:
- Synthetic Long Stock
- Synthetic Short Stock
- Synthetic Long Call
- Synthetic Short Call
- Synthetic Long Put
- Synthetic Short Put
I would recommend you read this here if you are interested in more details:
The Synthetic Positions provide practically the same exposure to gains or losses as their real counterparts, but they also provide some general benefits. Particular types provide particular benefits.
What are the generic benefits? Flexibility and cost-effectiveness.
Quoting from the source above:
- “Synthetic positions can easily be used to change one position into another when your expectations change without the need to close out the existing ones.”
- “When you already hold a synthetic position, it’s then potentially much easier to benefit from a shift in your expectations.”
Basically one can transition from a position to another with fewer transactions. Instead of closing the old position and opening another one, traders can simply add a new position that would lead to a synthetic position with the same exposure as closing and opening new ones.
And if a trader already has a synthetic position, adjusting your position to would be generally easier, without needing to completely change the positions.
Fewer transactions means less costs costs (commissions) and less losses due to fewer bid/ask spreads.
But we are not here to talk too much about Synthetic Positions in general.
Let’s move to the most interesting one for us.
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The Synthetic Short Stock
This is a good summary, from the same source above:
A Synthetic Short Stock is created with a married Call/Put, more specifically with a Short Call and a Long Put.
It provides the same exposure to gains or losses as a normal Short Position.
The advantages are quite interesting:
- Leverage: same leverage advantage as with single options, same exposure with a reduced investment (only premiums).
- Dividends: the owner of a Synthetic Short Stock position would not have to pay for a dividend in case there would be one.
It is important to notice some differences in relation to a real short position (i.e. to borrow a share to sell it in the market):
- time-limited exposure, given by the options’ expiration dates.
- lack of an initial cash inflow (no shares are sold, no money is gained upfront).
- absence of the practical difficulties and obligations associated with short sales (borrow requirement, borrow fees, reporting).
Let me stress out the most important difference for the purposes of this post: for Synthetic Short Stock, no shares are sold, no shares are borrowed.
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The standard Short Sale
For completeness and comparison, let’s also recall what is actually a normal Short Sale.
A Short Sale (or short-selling) is when a share is borrowed and then sold in the market, with the expectation that the share price will drop and the seller would be able to buy the share again in a later date for less and pocket the profit.
There are several things involved and several consequences:
- There is a requirement to borrow the share, or at least locate a borrow, before selling the share short.
- There is the need to pay a borrow fee for the time the share remains borrowed.
- There is the obligation to report such short sales to Finra due to rule 4560.
In summary, a short sale is what leads to the definition of Short Interest.
Directly from Finra:
They make it too complicated.
In simpler words, from Investopedia:
“Short Interest is the number of shares that have been sold short and remain outstanding.”
Please note that the definition above and the one from Finra, both include short sales for located shares and not located shares (naked shorts).
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Synthetic Short Stocks: no shares are sold in the market
Let’s recap the differences between those two types of short positions, with focus in one particular aspect related to shares being sold in the market.
The most important difference is that upon the creation of a Synthetic Short Stock position, no share is directly sold at all.
Only the standard short executes a sale in the market, thus increasing the amount of shares that are entitled by someone.
That means that the Short Interest as currently defined is not directly affected by the creation of Synthetic Short Stock positions.
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- “But Theo, why has Finra then proposed that Synthetic Shorts should be reported, as you depicted in your last post?”
I believe that Finra proposed that the Synthetic Short positions should be disclosed, additionally to the Short Interest as currently defined.
Only if the information on Synthetic Shorts would be provided separately would Finra be able to achieve what they proposed above, i.e., to understand "the scope of market participants’ short sale activity, specifically regarding the use of less-traditional means of establishing short interest".
In other words, Finra would be somehow redefining Short Interest for them, for their purposes.
)
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How Synthetic Short Stock can apply indirect downward price pressure and indirectly increase Short Interest
Standard shorts apply direct downward short pressure and directly affect the Short Interest, because a new share is sold in the market. The amount of shares “entitled” increase.
Synthetic Short Stocks do not apply any such direct downward pressure nor increase Short Interest, as no share is sold. On the other hand, there can be an indirect downward pressure and indirect increase of Short Interest, which is quite difficult to explain because it revolves around how options are hedged.
Let’s begin recalling that a Synthetic Short Stock is composed of a sold Call (Short Call) and a bought Put (Long Put).
The counterparty for those 2 options is a Market Maker, who buys the Call and sells the Put to the other market participant that is establishing a Synthetic Short Stock position.
The MM has now an opposing exposure in relation to the owner of the Synthetic Short Stock. By selling the Put the MM loses money if the stock price falls. By buying a call the MM loses money if the stock price falls.
The Market Maker is supposed to hedge to maintain a delta neutral position.
How can the MM hedge? There are many alternatives, let’s see some of them.
1. Delta Hedging by Shorting the Stock
The MM would simply short the stock, thus creating downward price pressure and also increasing the Short Interest.
2. Delta Hedging using Options
The MM could use other Options to hedge, for example by buying Puts with a lower strike price and selling calls with a higher strike price.
Please notice that by hedging with options there would be no direct downward price pressure on the stock. No shares are sold directly when buying such options. Nevertheless, the MMs may still need to adjust their overall exposure, which could involve some level of buying or selling of the underlying stock, depending on the delta and gamma of the options they are trading, as the MMs would need to delta hedge and gamma hedge.
Similarly, there is no direct impact on the Short Interest. Only if as a consequence of the delta or gamma hedging described above, the MM would need to sell shares short to hedge, then there would be some impact on the Short Interest.
The MM may continue to dynamically adjust its hedge over time (dynamic hedging).
3. Hedging via Equity Swaps or Total Return Swaps (TRS).
In a TRS, one party (the receiver) agrees to pay the total return (capital gains or losses + dividends) on the stock, while the other party (…
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