The two major synthetics -- long stock and short stock -- involve options but mirror price movement in 100 shares of stock. These may reduce market risks while setting up positions with zero cost - the best leverage of all.
Synthetic long stock is a combination of one long call and one short put, opened with the same strike and expiration. This combined position mirrors movement in the underlying security, and works best when the stock price rises.
Synthetic short stock combines one long put and one short call and, like the long version, this also mirrors movement of the stock. It provides the best results when the underlying stock price falls.
The cost of the long option in each case is offset by income from the short option, so the position costs little or no cash -- it might also produce a small credit.
For most traders, the short position is the biggest problem. Although synthetic allow you to benefit from a position equivalent to 100 shares of stock, the short side in either of these is potentially troubling. A solution, at least for the synthetic short side, is to own 100 shares of the underlying. This converts the synthetic short stock to a combined position: an insurance put and a covered call. This three-part strategy (100 shares of stock, one long put, and one short call) is a collar, and is one of those great option strategies that virtually eliminates market risk for no added cost (or benefit) beyond owning shares. The collar is great if you are in the stock mainly for dividend income, or as a temporary protective measure against expected volatility.
Also remember that you can close short positions to avoid exercise, roll them forward, or cover them later. You have many solutions. The key to reducing synthetic position risks is to be aware of how volatility affects positions. By timing entry based on volatility, your market risk is reduced substantially.
Strategies like this are designed to duplicate stock price movement without having to buy 100 shares. This is an amazing advantage. However, the synthetics are going to work best when you time not only the direction of movement, but also the volatility trend. This can be accomplish in a quick-and easy way, lowering risks while leveraging your positions. Check volatility edge to learn more.
Michael C. Thomsett (firstname.lastname@example.org) is author of FT Press’s “Options Trading for the Conservative Investor.” He is an instructor with the New York Institute of Finance. He teaches five courses: “Swing Trading with Options,” “The Amazing World of Options,” “Synthetic Options Strategies”, “Options timing and dividend income strategies,” and “Using candlestick reversal and continuation patterns to improve timing.” He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com