3 Tips for Trading Synthetic Longs

02/10/2015 8:00 am EST

Focus: OPTIONS

Michael Thomsett

Founder, Thomsett Publishing Website

Synthetics are intriguing and interesting because they provide the possibility to profit from stock price changes, without needing to buy shares of stock, writes Michael Thomsett of ThomsettOptions.com.

Among the many options strategies available, one of the most interesting in synthetic long stock. This involves a long call and a short put opened at the same strike and expiration.

The name 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, the stock is trading at about $60 per share. The value of two sets of April 60 calls and puts were:

April (1 month)
Call 1.46
Put 0.75

January (10 months)
Call 3.65
Put 4.20

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, the January call can be bought for 3.65 ($365). However, at the same time, the January put is sold for 4.20 ($420). This produces a net credit of $55.

The changes in value will mirror movement in the stock as it moves upward, point for point. The call's intrinsic value above its 60 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.

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 $6,000 and the synthetic long stock position yields income of $55. Collateral required is probably quite small because of the long/short offset.

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. However, the net cost to open the position is close to (or below) zero.

Synthetic long stock requires maintenance of minimum margin equity. However, it should not require a doubled margin, since one side or the other (call or put) would be exercised but not both of them. 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 very 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.

By Michael Thomsett of ThomsettOptions.com

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