Breaking Down a Synthetic Long Options Strategy

This options strategy allows traders to simulate a long stock position at a reduced cost of entry

by Emma Duncan

    Published on Sep 13, 2018 at 3:27 PM
    Updated on Sep 13, 2018 at 3:27 PM

    As we continue to maneuver the second half of the calendar year, now is the perfect time for investors to refresh on important options strategies. One notable strategy worth focusing on is the synthetic long stock position, which utilizes options to mimic the risk vs. reward profile of a straightforward stock purchase. Below we will take a look into how traders can exercise this strategy to stretch their dollar even further.

    Understanding the 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.

    How a Trader Can Utilize the Approach

    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).

    Winning vs. Losing With a Synthetic Long Strategy

    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.

    Switching gears, losses 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.

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