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Options Trading: Creating a Synthetic Long Stock Position

Posted March 18, 2010

Topics: Finance & Investing

You want to benefit from market movement, but you are concerned with market volatility and downside risk. One solution is to open a synthetic long stock position using options. This requires much less cash and has significantly lower risks -- but at the same time the position changes in value to the same degree as owning shares.

To set up a synthetic long stock position, you buy one call and sell one put at the identical strike. This position involves little or no cost, because the cost of the long position is offset by income you receive for the short position. It is possible to even have a small net credit from this two-part trade.

To demonstrate how synthetic long stock works, compare price movement of stock to the net difference in option values at the same time. For example, if stock is currently selling at $35 per share, and you set up the synthetic long stock position (buying one call and selling one put), what will happen as the stock price changes? Assuming that both call and put were valued at $300, here is what happens at different price points:

Stock   35 call              35 put              Net change     

Price    value                value                in options       

$25      $ - 300             $ - 700             $ - 1,000         

  30         - 300               - 200                -    500            

  35         - 300                 300                         0

  40           200                 300                      500

  45           700                 300                   1,000

The net profit or loss in the option positions is identical to the outcome you would have experienced by owning 100 shares of stock. for example, if the stock value falls to $30 per share, either owning stock or opening a synthetic long stock position causes a loss of $500. And if stock rises to $45, either owning shares or opening the option-based equivalent creates a profit of $1,000.

The market risk is identical. The big difference is the cost. Buying 100 shares of stock costs $3,000. Opening an offsetting synthetic long stock  position costs zero or at worst, a very small debit. This occurs because the long position may be slightly more expensive than the short, the spread factor is different for buying and selling, and trading costs have to be brought into the picture as well. Even so, the comparative amount of capital at risk is considerably different with the synthetic long stock position.

The strategy demonstrates how options can be strategically employed beyond simple speculation, to enhance your portfolio. In this example, you benefit or assume risks identical to owning stock, but with no cost. The option positions are going to expire in the future, so the strategy only lasts as long as the life cycle of the options. But based on the fact that the position is virtually without cost, why would that matter? The position or either side can be closed at a profit at any time, or after expiration it can be repeated.