Synthetic Long Stock ~ Call and Put Options
Synthetic Long Stock
Options can be used to create positions that act like the underlying investment. Every underlying, option and complex option position has a synthetic equivalent. In other words the tactical option investor can put together option positions that will act in a similar fashion to another option or underlying position. We’ll start with a simple one the synthetic long stock position. A synthetic long stock position will act like owning a long position in an underlying investment whether it’s an individual stock or an ETF. A synthetic long stock consists of a short put combined with a long call. Remember we used the long call position when we wanted to participate in the upside of the market and have limited exposure to the downside. We used the short naked put position to accumulate shares of stock. The naked put has profit potential limited to the premium received for the put if the market makes a large move to the upside the investor does not participate. The long call will participate in a large upside move, but will decay over time if the market is flat, and of course will decline in value if the market goes down. The synthetic long stock is generally put on for a credit when the investor is willing to take on the full risk of stock ownership. They can also be put on for a debit. The short put is sold and the long call is purchased. The tactical option investor is targeting an underlying that they are willing to own if it goes below the strike price of the put, but also wants exposure to the upside to participate in gains if the underlying makes a large upside move. For example say we want a long position in the S&P 500 index. We could purchase 100 shares of SPY for about $13,400. Or, we could sell a LEAP put and buy a LEAP call that expires in about one year, January 2012. The 130 put is currently priced at $8.15 and the 135 call is priced at $8.05. This trade would be opened for a net credit of .10 or $10 for one contract. The margin requirement would be 20% of 130 or $2,600. That means that the difference between the cost of the 100 shares of SPY and the margin requirement for the synthetic long stock position, the $10,800, could be invested in a safe interest bearing Treasury bond for the duration of the trade. It provides for a better use of capital. If the SPY is below in a year we’ll purchase the shares at 130 plus our credit for a net cost of $129.90. Between 130 and 135 we’ll keep the $10. Above 135 we keep the initial credit plus any price above 135. If the S&P has a 10% gain for the year. It would close at $147.95. The profit from the synthetic would be $1,305, which is a 50% gain on the margin requirement, plus the interest on the $10,800 which was set aside in a treasury obligation. At today’s low interest rates the return on the bond is not that much, but in a higher rate environment it can add up. If rates were at 5% the return would be $540 at 1% the return is only $108. The key point is that a 10% move in the market gave us a 50% gain on the margin requirement and the risk is the same. If you just bought the 100 shares outright and paid $13,400 you’d still have a nice gain of $1,395 or 10%.