Using synthetic puts to protect shorts when there's a squeeze

The Eurozone fiasco means stock indices have been falling rapidly at times, which has been and continues to be an opportunity via shorting CFD indices. But each time the market drops there's a subsequent bounce and shorts are squeezed to the point where they have to be closed. There is a way, however, to keep a short position without worrying about the squeeze - synthetic puts.

The diagram below shows how to create a synthetic put. If you're short the index CFD (short stock in the image), buy a long index call against it. Put-call parity means this will have a payout similar to a long put.

Let's take a look at an example. As I am Dutch I always keep an eye on the AEX Index:

 Example:

• Short 100 AEX CFDs with the AEX at 295
• Long the June AEX 295 Call option – 1 contract at 7.55 (EUR 755)
• Your break-even becomes 287.45

So what you've done is pay 7.55 points on the index until June expiry for full protection if the market rises during the next two months and your short is intact.

But there are additional benefits to doing this with synthetics - after all you could have just bought the put. Synthetics are more flexible because they are created with more than one position, meaning you can close positions at different times to take advantage of developing situations.

For example, if you are happy with the profit made on the AEX position, you can close the short on the index and hold on to the call waiting for a bounce.