Using Options to Capitalize During Election Uncertainty

For traders who want to invest in a stock without buying it outright, a synthetic long options strategy can deliver a similar risk/reward setup at a fraction of the cost

Nov 4, 2016 at 1:27 PM
facebook twitter linkedin

With the market's "fear gauge" -- the CBOE Volatility Index (VIX) -- attempting to top its all-time win streak ahead of next week's U.S. presidential election, and with the S&P 500 Index (SPX) just off its longest losing streak since the financial crisis, many traders are wary about sinking too much capital into stocks right now. However, by utilizing the synthetic long options strategy, speculators can simulate stock ownership at a fraction of the cost, while also minimizing risk.

A synthetic long involves purchasing near-the-money call options, and then partially funding the calls by simultaneously selling puts at the same strike. Both the calls and the puts should share the same expiration date to achieve the desired result. Ideally, the underlying shares will increase in value, which will keep the sold puts out of the money as the calls increase in value.

However, losses can rack up quickly, so it is important that an option trader is confidently bullish before attempting a synthetic long option play. Due to the substantial downside risk involved, there is a margin requirement associated with a synthetic long -- which will generally be equivalent to your broker's requirement for any put-sell position. And, for those traders who don't want to assume as much risk, consider simply buying the call -- a strategy that offers limited losses, but will cost more on entry.

As an example, imagine a trader is bullish on Stock XYZ, which is currently trading at $50 per share, and she expects the stock to rally after earnings in a couple of weeks. To buy 100 shares of XYZ requires an initial investment of $5,000. As an alternative, she could  initiate a synthetic long by buying to open a December 47.50 call, asked at $2.80, and simultaneously selling to open a December 47.50 put, bid at $0.80, which results in an even debit of $2 per pair, or a $200 initial investment (since an option controls 100 shares of the underlying).

If XYZ rallies to $60 after earnings, the shares would be worth $6,000 -- a $1,000, or 20%, profit for the shareholder. The synthetic long strategist, meanwhile, would be able to let the puts expire worthless, and her calls would be worth at least $12.50 in intrinsic value ($60 - 47.50), or $1,250 total (x 100 shares) -- a 525% profit from the initial investment. In fact, the options strategist's profit would accrue the higher XYZ trades above breakeven at $49.50 (strike price of 47.50 + $2 initial debit).

On the flip side, if XYZ changes course and ends lower -- say, at $40 per share – the stock trader would lose $1,000, or 20%, of her initial investment. For the synthetic long strategist, the 47.50-strike call contract would be deep out of the money, and buying back the sold put -- if it's not assigned -- would cost at least $7.50 (47.50 - current stock price of $40), or $750 (x 100 shares), resulting in losses of about $950, including the $200 debit. While that doesn't account for brokerage fees or time value, that's still roughly in line with the dollar losses suffered by the straight stock trader.

For a trader who is confidently bullish in a particular equity but doesn't want to buy a stock outright, executing a synthetic long can lead to a similar payoff at only a fraction of the cost. However, given that big losses can still occur, it's always important to do your research prior to investing. Still, with today's highly volatile market, making the right option play can lead to huge rewards. 

Let us help you profit from market volatility. Target big gains in short order with a 30-day trial of Schaeffer's Weekly Volatility Trader!

Make the Most of the next Expiration Week Countdown!


Special Offers from Schaeffer's Trading Partners