Introducing the Synthetic Short.
music selection: “Burn In Hell” — Twisted Sister
First I want to make the case for shorting CNQ. CNQ is an oil and gas company that has significant exposure to deposits that are expensive to produce from. With oil looking to be at a new long term equilibrium price of 40-50 dollars a barrel, they are due to see some pain. The company also currently has a rich multiple making it an attractive short. A large portion of production comes from Canadian Tar Sands projects. Tar Sands produce a type of heavy, sour crude known as Bitumen, that fetches a lower price on the markets than WTI or Brent crude. It is also expensive to mine and has a break even price around 55 to 60 dollars a barrel by most estimates.
CNQ has a large Tar Sands project known as Horizon that is already projected to be about 10 billion dollars over budget; versus an original budget of only 7.6 billion. The project is also a disappointment in that it was originally projected to produce 500,000 barrels a day. The current projection is down to 250,000 barrels per day, cutting the economic justification in half. Management reports its current mix includes 24% of its oil and gas sourced from Tar Sands and projects its long term mix to grow to 38% from same. The company is betting its future on a high cost source of oil. And it is executing that strategy poorly. I think this company is an excellent short candidate but borrowing costs and a rich dividend yield make shorting the underlying unattractive.
Enter the Synthetic Short. It is possible to use options to set up a profit/loss profile that mirrors shorting the underlying. As a bonus, this position is immune to paying a third party dividends or paying the broker borrowing fees. The process works best with long dated options and Jan 2018 LEAPS are available on CNQ.
To execute a synthetic short, you sell a call and buy a put at the same near the money strike. In this case, I sold CNQ180119C00030000 for 4.35 a share and bought CNQ180119P00030000 for 4.58. This is what is known as a “spread” with a “net debit” of 20 cents a share. The underlying was at 30.19 at the time the spread was purchased so there is a negligible drag of about 40 cents a share to set up the spread. This will ultimately be less expensive than paying borrowing fees and payments in lieu of dividends.
The time value of the sold contract offsets the time value of the purchased contract and will continue to do so as both positions experience time decay. So the P&L profile is the same as shorting the underlying. If the price falls to 29 dollars, the call will be out of the money by a dollar while the put will be in the money by a dollar. Thus, unwinding the position would yield about a dollar in profit, the same as a short position in the underlying stock. The opposite can be said for a price of 31 dollars. The call would be in the money by a dollar and the put out of the money by a dollar. Unwinding the position would result in a loss of about 1 dollar a share.
It is important to note that while this approach does not result in a margin loan, it does use leverage. You are investing with equity that belongs to the broker rather than yourself and your returns and losses are magnified by the same. So don’t overdo it. I am buying two spreads here, setting my underlying exposure to 6,000 USD. That is similar to the 5,000 exposure I set for my direct shorts.
Devour your prey raptors!