Synthetic Put

A put represents the option (meaning the right, but not the obligation) to sell an underlying asset (like a stock) at a pre-set price at a pre-set point in the future. Essentially, you use it as a way to bet that the price of a stock (or whatever asset) will decline.

AAPL is trading at $200. You buy a put with a $190 strike price. Shares fall to $170 by the time the put expires. You can exercise the put, forcing someone to buy the stock from you at $190 (shares you can just grab in the open market at $170, making you a profit of $20 each, minus the expenses related to purchasing the put). The nice thing about the put is that there's no real penalty for the stock going up. You lose the amount you paid for the option, but otherwise, no harm, no foul. If AAPL's stock rises to $225 a share, and you're holding a put at $190, you just let the put expire. You don't have to sell the shares at $190. You have the option.

This scenario is different than a short sale, another way of betting that a stock will go down. That process involves borrowing stock, selling it on the open market, and then hoping it declines in value. If it does, you buy the shares back at the lower price, return them to the person you borrowed them from, and pocket the difference. However, if the stock rises, you can lose tons of money. Theoretically, an infinite amount (although...you're liable to cover your short at some point, rather than let the stock actually climb to infinity).

A synthetic put is essentially a short, but with a hedge involved. You short the stock, but simultaneously buy a call for the same stock, with a strike at the same price where you shorted the shares. A call represents the opposite of a put. It gives the holder the right, but not the obligation, to buy shares at a pre-set price at a pre-set time. Having the call protects you from the downside of the short sale. If the AAPL stock rises to $225, no fear. You purchased a call. You just exercise the call at $200 (the point at which you shorted the stock).

It's essentially a do-over. You use the call to purchase the stock at the original price, and return that to the person you borrowed it from. The deal has the same outcome as a put. Which is why it's known as a "synthetic put." It provides the same action as holding a put...without actually using a put to do it.