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Options Trading: Synthetic Long Stock, Low-cost and Low-risk

Posted April 21, 2011

Topics: Finance & Investing

Anyone who wants to buy 100 shares of stock will naturally be concerned with the risk that a stock’s price will decline. There is one options strategy that enables you to profit from ownership of 100 shares of stock, without actually owning 100 shares. At the same time, the strategy costs almost nothing to open and risks are lower than those of stock ownership.

If this sounds too good to be true, think again. Synthetic long stock is a position combining one long call and one short put. These are opening at the same strike price. The cost of the long call is offset by the premium you receive for selling the put. This means the overall position costs very little and may even net you a small credit.

If the stock price rises, the call matches the stock’s intrinsic value point for point. You do not have to worry about time decay because the net coast of the option positions is at or close to zero.

If the stock price falls, the short put gains in value, meaning you lose in the same way you would lose by owning 100 shares of stock. However, there is a very important distinction. With the short put, you can close to avoid the risk; this may even be possible at a small profit because the put’s value declines due to time decay. The put can also be rolled forward to avoid exercise. You cannot roll stock in this manner, so the risk is far more limited than it is in ownership of 100 shares.

Finally, the cost of synthetic long stock is zero, compared to the cost of buying 100 shares. So 100 shares of a $50 stock can be bought for $3,500 (or $1,750 on margin). In comparison, you can open a synthetic long position for only the margin maintenance level.

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, 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. 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.

Michael C. Thomsett is an instructor with the New York Institute of Finance. He teaches three options courses: “Swing Trading with Options,” “The Amazing World of Options,” and “Synthetic Options Strategies.” 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. Thomsett’s latest FT Press book is Trading with Candlesticks. He also contributes to the CBOE newly-formed blog.