Synthetic stock -- created with options -- vastly reduces swing trading risk. It makes more sense to create synthetics than either of the two alternatives (buying/selling stock or swing trading with options alone).
The strategy involves buying one call and selling one put at the same strike (this creates a synthetic long stock position. The combined option values will mirror price movement in the underlying stock. However, because the position includes both a long and a short, the cost is very small. This synthetic position works best at the bottom of the swing, when you expect the price of stock to begin rising.
The opposite is to buy one put and sell one call at the same strike (this sets up a synthetic short sale on the underlying). The price action will mirror movement in the stock. This position is intended for use at the top of the price swing, when you expect a short-term price decline.
Five advantages you gain swing trading with synthetic stock:
1. Cost is much lower; even a credit position is possible. The long and short are offsetting, so the short premium you receive pays for the long position. In some cases, you can set up a synthetic position and earn a small credit.
2. Risk with synthetics is smaller than with stock. Instead of risking 100 shares of stock in either a long or short position, the risk of opening up offsetting options is quite small. You can cover a short position going into the money with an offsetting long, roll it forward, or cut losses by closing. You have the advantage of time decay, making losses on the short side unlikely; and if you time your synthetic stock position when implied volatility is high, you stand a better than average chance of profiting on the short side when volatility levels return to normal.
3. Short positions can be played without needing to short stock. Many swing traders only play the uptrends because they do not want the extra risk of shorting stock. The synthetic short position solves this problem by creating a position that changes in value just like 100 shares of stock, but without having to borrow stock and short it.
4. The smaller net dollar trade vastly increases diversification. You can swing trade many more stocks using synthetic stock positions, simply because you leverage your capital. The only real limitation is in the margin requirements imposed by your brokerage and by Regulation T. But even a modestly-sized portfolio can be broadly diversified using synthetics.
5. Synthetics including covered calls are even less risky. The synthetic short sale becomes a virtually riskless transaction when you also own 100 shares of the underlying. The short call is covered, and the premium you get for selling it pays for the long put.
The synthetic stock position poses an elegant solution for swing trading, and should be given a close look as a powerful strategy.
Michael C. Thomsett is 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.