Creating synthetic long stock lets you open an options-based position that behaves exactly like 100 shares of stock, but without requiring you to invest in shares. This also means that market risk is quite limited, because you have less cash sitting in the position.
An example: You want to buy 100 shares of stock which closed at $60.39 last night. But you don’t want to risk $6,039 to buy those shares and tie up capital. The solution is to create a synthetic long stock position in options.
The following options were available:
September 60 call 2.00
September 60 put 1.52
The synthetic long stock position consists of buying the call and selling the put at the same expiration. This position gives you a good tracking mechanism for very little cost. You buy the 60 call and sell the 60 put:
BUY September 60 call 2.00
SELL September 60 put -1.52
Net cost $0.48
This does not include transaction costs, so a real-life example has to be adjusted to reflect the actual net cash outlay. The chart below summarizes the values of each option at expiration, compared to the value of 100 shares of stock at different closing prices:
Price at September 100 shares
Expiration 60 call 60 put Net of stock
$65 + 3.00 + 1.52 + 4.52 + 4.61
64 + 2.00 + 1.52 + 3.52 + 3.61
63 + 1.00 + 1.52 + 2.52 + 2.61
62 0 + 1.52 + 1.52 + 1.61
61 – 1.00 + 1.52 + 0.52 + 0.61
60 – 2.00 + 1.52 – 0.48 – 0.39
59 – 2.00 + 0.52 – 1.48 – 1.39
58 – 2.00 – 0.48 – 2.48 – 2.39
57 – 2.00 – 1.48 – 3.48 – 3.39
56 – 2.00 – 2.48 – 4.48 – 4.39
55 – 2.00 – 3.48 – 5.48 – 5.39
The slight differences in outcome between the net option positions and the equivalent stock values are caused by the net difference of both stock values and option cost:
Cost of the synthetic stock position 0.48
Minus: Stock current value at opening price
adjusted to strike price of 60 – 0.39
Net difference 0.09
This net difference accounts for the nine-cents per share difference at each price point, between synthetic long stock and the value of 100 shares of stock.
The synthetic long stock position costs under $100 even with brokerage fees for the two sides of the position. In comparison, you need over $6,000 to buy 100 shares. However, the options position acts exactly like the stock for much less capital at risk. This is a truly effective application of leverage, but with much less risk. Synthetic positions are easily overlooked or ignored in the options world. But it opens up a range of potential for swing traders and would-be stock investors. The synthetic short stock position also offers a relatively low-risk alternative to shorting stock.
Synthetics deserve careful consideration. These positions can solve many problems relating to both risk and capital management.
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