How To Use Options To Mimic Risks, Rewards of Buying Stocks

A synthetic long options strategy is less expensive than buying a lone call

Oct 13, 2017 at 1:02 PM
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    It's no secret that buying call options is cheaper than buying a stock outright. For traders looking to stretch their dollar even further while mimicking the risk/reward of stock ownership, there's an even better alternative: a synthetic long options strategy.

    What Is a Synthetic Long Options Strategy?

    This strategy provides investors an opportunity to simulate the payoff of a long stock position at a reduced cost of entry. It's also cheaper than buying a single call, because the trade also involves selling a put. 

    To execute a synthetic long options strategy, a trader buys near-the-money calls while simultaneously selling puts -- usually at the same strike price -- which helps fund the calls. Since both the calls and the puts share the same expiration date, the strategy becomes profitable when the underlying security tops breakeven -- the call strike plus the premium paid -- within the options' lifetime. As the security's value increases, the calls also increase in value and the sold puts move out of the money.

    For Example...

    Say two traders, Trader A and Trader B, are both bullish on Stock XYZ. Trader A decides to buy 100 shares of Stock XYZ outright for $50 a share, investing a total of $5,000. Meanwhile, Trader B initiates a synthetic long with options expiring in about a six weeks.

    Specifically, he buys to open a 50-strike call for the ask price of $2, and sells to open a 50-strike put for the bid price of $1.50. Thus, after subtracting the credit of $1.50 from the debit of $2.00, it cost Trader B only 50 cents, or $50 (x 100 shares), to enter the trade.

    In order for Trader B to profit from the synthetic long, the equity would have to rally above $50.50 (strike plus net debit) before the options expire. Had he simply bought the 50-strike call for $2, his position wouldn't begin to profit until XYZ moved north of $52 (strike plus premium paid).

    If Stock XYZ Rallies

    Since both traders are bullish on the security, both expect Stock XYZ to rally above $50. Say Stock XYZ rallies to $55, making Trader A's 100 shares worth $5,500. Trader A would make $500, or 10% of the initial investment. 

    Trader B's 50-strike calls would have $5, or $500, in intrinsic value, while the puts could be left to expire worthless. After subtracting the net debit (50 cents) from the intrinsic value ($5), Trader B would pocket $450 ($4.50 a share at 100 shares) -- similar to Trader A's dollar gains, but a healthy 900% of the initial $50 investment.

    If Stock XYZ Tanks

    Losses, however, can add up quickly in a synthetic long options trade. If Stock XYZ tanks to $45, Trader A would lose $500, or 10% of the initial investment. Meanwhile, Trader B's calls would be deep out of the money, resulting in a loss of the initial investment of $50. Plus, Trader B would have to buy back the sold put -- if it's not assigned -- for at least $5 (intrinsic value). At 100 shares, this would cost $500. In all, Trader B would lose $550 -- similar to Trader A's dollar losses, but 11 times the initial investment.

    While the potential returns of a synthetic long options strategy are theoretically unlimited, more risk is attached than that of simply buying a call outright, since the synthetic involves sold puts. Thus, a trader should be certain the stock will rally above the breakeven price before implementing a synthetic long options strategy. If an investor is less sure a security will rally, he or she is better off buying a straight call.

     

    Minimize Risk While Maximizing Profits

    There is no options strategy like this one, which consistently minimizes risk while maintaining maximum profits. Perfect for traders looking for ways to control risk, reduce losses, and increase the likelihood of success when trading calls and puts. The Schaeffer’s team has over 41 years of options trading success targeting +100% gains on every trade. Rest assured your losses are effectively limited to your initial cost at the time of making your move! Don't waste another second... join us right now before the next trade is released! 

     


     


     
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