Among the many options strategies, one of the most interesting is synthetic long stock. This involves a long call and a short put opened at the same strike and expiration.
The name "synthetic" is derived from the fact that the two positions change in value dollar for dollar with changes in 100 shares of stock. However, the cost to open the position is close to zero and may even produce a small credit.
For example, a stock is priced at $50.35 per share. The value of the November 50 calls and puts are worth:
Because synthetic long stock involves buying a call and selling a put, longer-term positions do not present the time value problem usually faced by options traders. For example, in this example, the net cost is just about zero, adjusted for approximately $20 for trading costs. There remains very little cost to open synthetic position for one of each option. However, any uncovered short position also requires deposit of collateral in the margin account, which is one form of cost in addition to the options positions.
The changes in value will mirror movement in the stock as it moves upward, point for point. The call's intrinsic value above its 50 strike is going to be one dollar higher for each point of movement in the stock. If the stock moves downward, the put gains one point for each point in the stock; and because the put was short, this represents a loss - in fact, identical to the loss of just owning the stock.
The options are likely to track closer to movement in the stock because time value is going to disappear fast, and extrinsic (volatility) value will be less of a factor in overall premium value as expiration approaches.
Some risk factors to remember:
1. The market risk in synthetic long stock is the same as that of owning 100 shares of the stock. However, in this example, owning shares costs $5,000, which can be bought for 50% on margin; and the short put is subject to margin requirements.
2. Losses in the short put are mitigated by closing the position, rolling it forward, or buying a later-expiring long put. Losses in long stock cannot be managed in the same way. Losses have to be taken or waited out.
3. Holding the short put represents the primary risk in the position. However, this is the same downside risk as owning 100 shares of stock. The net cost to open the position is close to zero until the collateral requirements are considered. On a practical level, the most likely outcome would be to close the short put once it becomes possible to take profits, and leave the long call to appreciate. This is the best of both worlds: low-cost call with profit potential paid for by a short put position.
Synthetic positions can also be opened on the short side, involving buying a put and selling a call. This may seem higher-risk than the synthetic long stock; but it can be made more conservative by covering the call. This sets up a collar that acts like short stock.
Synthetics are intriguing and interesting. They provide the possibility to profit from stock price changes, without needing to buy shares of stock. The offsetting cost/income also makes it practical to use long-term options without needing to worry about time decay.
The collateral requirement has to be kept in mind as a limited factor in the synthetic strategy. To learn more about collateral, download the free report from the CBOE, CBOE Margin Manual.
As with any strategy, appreciating the risks as well as the profit potential is essential.