Synthetics: Leverage with Less Risk

03/07/2014 8:00 am EST

Focus: OPTIONS

Michael Thomsett

Founder, Thomsett Publishing Website

Creating a synthetic long stock lets you open an options-based position that behaves exactly like 100 shares of stock, but without requiring you to invest, writes Michael Thomsett of ThomsettOptions.com.

If you want to buy 100 shares of a stock at $60, but you don’t want to risk $6,000 to buy those shares and tie up capital, the solution is to create a synthetic long stock position in options. This means that market risk is quite limited, because you have less cash sitting in the position.

The following options are available:

September 60 call 2.00
September 60 put 1.52

The synthetic long stock position consists of buying the call and selling the put at the same expiration. This position gives you a good tracking mechanism for very little cost. You buy the 60 call and sell the 60 put:

BUY September 60 call 2.00
SELL September 60 put -1.52
Net cost $0.48

This does not include transaction costs, so a real-life example has to be adjusted to reflect the actual net cash outlay. The chart below summarizes the values of each option at expiration, compared to the value of 100 shares of stock at different closing prices:

chart
Click to Enlarge

The slight differences in outcome between the net option positions and the equivalent stock values are caused by the net difference of option cost at a net of 0.48.

The synthetic long stock position costs under $100 even with brokerage fees for the two sides of the position. In comparison, you need $6,000 to buy 100 shares. However, the options position acts exactly like the stock for much less capital at risk. This is a truly effective application of leverage, but with much less risk. Synthetic positions are easily overlooked or ignored in the options world. But it opens up a range of potential for swing traders and would-be stock investors. The synthetic short stock position also offers a relatively low-risk alternative to shorting stock.

Synthetics deserve careful consideration. These positions can solve many problems relating to both risk and capital management.

By Michael Thomsett of ThomsettOptions.com

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