What Are Options | Synthetic Long Stock

Options Strategies: Synthetic Long Stock

Often there are many securities that investors would like to own for their portfolio but they are hesitant to risk a large amount of capital that is often required to establish a position. In this scenario, where an investor would like to purchase shares of a specific company, but doesn’t want to tie up a large amount of capital, the investor should consider setting up a synthetic long stock. Creating a synthetic long allows an investor or trader to open an options-based position that simulates owning 100 shares of stock without requiring a large initial investment. The main advantage of the synthetic long strategy is that it minimizes the capital required to enter the trade as compared to purchasing 100 shares outright.

A synthetic long stock position is created via purchasing a call option contract and selling or “writing” a put option, to offset the cost of the call, on the same security and at the same strike price. This is an unlimited profit, unlimited risk options strategy that can be used when the trader is bullish on the underlying security but wants a lower cost alternative to purchasing the stock outright. First, let’s examine the basics.

A call option is a contract that gives the buyer the legal right to buy shares of the underlying stock at the strike price, before the expiration date. For this right, the buyer pays the seller a premium, which the seller collects and keeps. The buyer is never obligated to exercise his right to purchase the stock and can allow the option to reach the expiration date, at which point, it expires and becomes worthless.

If you would like to learn more details about purchasing calls, head to this post.

For more information about using calls to increase your portfolio income, read my post on selling covered calls.

A put option is a contract that gives the buyer the legal right to sell shares of the underlying stock at the strike price, before the expiration date. For this right, the buyer pays the seller a premium, which the seller collects and keeps. The buyer is never obligated to sell the shares and can allow the option to reach the expiration date, at which point, it expires and becomes worthless. Conversely, the seller is obligated to buy the stock at the strike price when exercised. Typically, one put option equals the right to sell 100 shares of the underlying stock at the strike price, before expiration.

For more information on using puts to increase your portfolio income, read my post on selling puts.

Creating a synthetic long stock is a cheap way to enter a position in a specific company. The position usually involves little or no cost because the cost of the call option is offset by premium received from the sale of a put option. However, this strategy is not without risk.


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First, let’s examine the pros and cons to creating a synthetic long stock position. Pros:

  • Increased leverage
  • Dramatically reduced capital requirement
  • Maximum profit is unlimited and will increase as long as the underlying stock price continues to rise

Cons:

  • Increased leverage can work in reverse
  • Maximum loss limited only by the stock at zero
  • Risk of assignment
  • Cannot collected dividends
  • Limited life span equal to the contract’s expiration date

Now that we’ve been over the basics let take a look at an example: An investor would like to own shares of the Intel Corporation (INTC), which has a current market price of $21.02. The investor’s sentiment is bullish on INTC and he would like to purchase a substantial stake in INTC. The problem is that this investor does not have a large amount of capital to invest. Purchasing 100 shares of INTC would require an investment of $2,102. Instead this investor decides to establish a synthetic long stock position. The investor purchases the 20 Jan 2012 call option contract for $2.58 and simultaneously sells the 20 Jan 2012 put option contract for $2.04. This synthetic long position costs the investor $54 (258-204), yet gives him the power to control 100 shares of INTC, more or less the equivalent of purchasing 100 shares outright.

Outcomes

First, at expiration on Jan 21st 2012, INTC could be trading $20/share. This means that both the call and put expire worthless and the investor loses the cost of the synthetic long, in this case $54. Since the trade had a net debit of $54 to create the trade his break-even point is $20.54.

Second, at expiration on Jan 21st 2012, INTC rallied to at $30/share. In this scenario, the Jan 20 put will expire worthless but the long Jan 20 call will expire in the money and have an intrinsic value of $1,000. However, since the trade cost an initial debt of $54 subtracting the cost means an approximate profit of $946. The rate of return on this trade is approximately 1,600%. What if the investor had simply purchased 100 shares of INTC outright? The investment would cost him $2,102 and would now be worth $3,000, giving him $898 profit. The rate of return on this trade would be 43%. In dollar terms the profit is almost identical, but the rate of return using the leveraged options trade is much higher.

Thirdly, at expiration on Jan 21st 2012, INTC sank to $10/share. The Jan 20 call will expire worthless but the short Jan 20 put will be in the money and expire with an intrinsic value of $1,000. To repurchase the put the trader would need to pay $1,000, thus meaning a $1,054 loss. What if the investor had purchased 100 shares of INTC outright? The investment would cost him $2,102 and would now be worth only $1,000 meaning a loss of $1,102. This is nearly equivalent to the synthetic long stock position.


Approximate Trade Value at Expiration

In conclusion, through this example one can see the power and weakness of leverage. An initial investment of less then $100 can be leveraged into substantial gains or losses. These examples do not include trading costs, which will affect the actual rate of return. A synthetic long stock can be utilized when a trader wants to take a position in a specific stock for a relatively small cost. In comparison, real stock ownership has the advantage of unlimited life and dividend collection while the synthetic long can expose an investor to large risk if the timing of the trade is incorrect.

In order to trade options one must have an options approved broker such as E-Trade or OptionsXpress.

Don't forget to check out my other posts here!

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