Long Stock creates an option position that can give dollar gains or losses
equivalent to owning stock, but with vastly increased leverage.
option-info and options-graphs sites:
Strategy: Synthetic Long Stock
Buy call and sell put at same strike price. If you use a strike above
the current stock price, you will receive a credit for the entry. If you
use a strike at or below the current stock price, you will pay a debit
for the entry.
when: Stock rises.
when: Stock falls.
Loss : Limited only by stock falling to zero.
Calculation: Usually very close to stock price at the time of entry.
compared to stock: Tremendously increased leverage, much less capital
compared to stock: Tremendously increased leverage works to the downside
as well, no dividends, limited life.
Requirement : If you maintain enough cash to buy the stock at the
strike price of the short put, your broker will consider the short put
to be a CSEP (cash secured equity put), with no further margin requirement.
If the short put is considered "naked", then the minimum margin
would be 10% of the strike price of the short put times the number of
shares represented, but probably more.
Equivalent: Long Stock.
Long Stock has the same profit graph as long stock, during the life
of the options.
- One interesting
thing about Synthetic Long Stock is that the time to expiration and
the IV do not usually matter much - the overall position will be priced
about the same whether you use an expiration next month or a year from
now, at high IVs or low IVs. So it is to your advantage to use the longest
time to expiration and give the position as much time as possible to
work in your favor.
- The leverage
is tremendously increased compared to stock ownership. Using the example
graph, a $9 investment could turn into $999 on a ten point rise in the
stock, or a return of 11,100%. But, leverage works to the downside as
well. The $9 investment could turn into a $1009 loss if the stock fell
- If you
try to protect the downside by buying a put at a lower strike, the graph
is the same as a Long Call, and you might as well use the Long Call
and save commission expense.
Stock is a demonstration of why "Put-Call Parity" exists.
Put-Call Parity means that the prices for puts and calls always have
a direct relationship. If one gets out of line, arbitrageurs can step
in and make risk-free trades, causing the relationship to return to
normal. For instance, if it were ever possible to enter the example
trade for a credit of $10, "arbs" would buy all the synthetic
stock they could, and short equal amounts of the real stock at the same
time. Then no matter where the stock went by expiration day, they would
have a $1 per share profit locked in.
the Synthetic Long Stock strategy gives you a position equivalent to
long stock, you might also consider writing OTM calls against the position,
using the nearest expiration, in order to reduce the overall cost of
the position. This creates a sort of "synthetic covered call".
If the stock rises to the strike you sold, you will need to close out
the synthetic long stock for a gain, since you do not actually own stock
to be called out of. Also, since you do not actually own stock, your
broker will not see this as a covered call with no margin requirement,
but as a bull call (you own a call with a lower strike and sold a call
with a higher strike).
- Just because
Synthetic Long Stock exists does not mean you should ever use it instead
of real stock or other bullish option strategies. Real stock has the
distinct advantage of unlimited life and possibly dividend income. Synthetic
Long Stock exposes you to large risk if your purchase timing is anything
less than perfect.
said that, Synthetic Long Stock might be an acceptable strategy for
"bottom fishing" in cheap stocks. Say there is a stock that
has sold off to $1 a share, but you think over time it will recover.
You could enter a long-term synthetic long stock position using the
$2.50 strike, for a credit of about $1.50 a share. As long as you keep
your position sized such that a $1 a share loss is acceptable, you could
reap very large percentage gains, with no cash invested, if the stock
recovers to anywhere over $1 a share.