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Options: Comparison of Risks in Synthetic Stock

By  Jun 28, 2012

Topics: Finance & Investing

The use of offsetting option positions creates "synthetic stock" - the no-cost or low-cost option combination behaves just like stock. The risks in the position, by the way, are the same as those risks in 100 shares, but for much less cash outlay.

A synthetic long stock position costs of a long call and a short put, opened as close to the money as possible. It is best suited for underlyings you believe will rise in value. As this occurs, the call gains one point of intrinsic value for each point the stock gains, and the short put will expire worthless.

A synthetic short stock position is the opposite: a long put and a short call, opened close to the money. It works best when you expect the underlying price to decline. For each point the stock loses, the put gains one point and the short call will expire worthless.

But what about the risks of holding short calls or puts?

Actually the risk is no greater than the risk of being long 100 shares (for the synthetic long stock) or short 100 shares (for the synthetic short). The combined option position will gain or lose one point for each point of movement in the stock.

The advantage is found in the zero or close to zero cost. The long position is mostly paid for by the short, and in some cases you even get a small credit. The only cash demand is the margin requirement, but you will not have to buy the 100 shares. And with the short options, if they go in the money you can roll them forward to avoid or defer exercise, something you can never do with stock.

This leveraged approach to playing the price of a stock makes great sense because you benefit in the same way as owning 100 shares, but for virtually zero cost. You can also avoid or defer exercise. The synthetic stock position is a worthwhile strategy for managing your portfolio and its risks.