Synthetic Long Stock - A Lower Level of Risk than Buying Shares?

In a previous blog, I discussed synthetic short stock, an options position that duplicates price movement of the underlying. It consists of a long put and a short call.

Now think about the opposite, synthetic long stick -- another position with low cost, low risk, and great leverage.

This strategy combines a long call and a short stock at the same strike. The market risk is identical to that of owning shares of stock (if the stock price declines, the put rises in value, could be exercised, and result in 100 shares put to you above market value).

This “loss” is the same as a loss from just owning stock. But two important considerations: Unlike owning stock, you can avoid exercise of the short put; and also unlike owning 100 shares of stock, the synthetic short stock position costs little or nothing to open.

An example: Google GOOG is an expensive stock, closing on April 6, 2012 at $632.32. To buy 100 shares, you need cash plus margin of $63,232. But if you believe the stock is going to appreciate over the next month or two, an alternative is to open a synthetic long stock position.

The May 635 call was worth 25.10 and the same strike put was at 27.40. If you buy the call and sell the put, you net out at a credit of 2.30 ($230). But the position will move in exactly the same way as 100 shares of stock.

The big risk here is that if the stock price falls, you could end up having 100 shares put to you at $635, a commitment of $63,500. So if the stock price fell to $600, you would be out $3,500. But unlike a loss on 100 shares of long stock, you can avoid exercise by (a.) closing the put once time value declines; (b.) covering the short put with a different long put; or (c.) rolling forward to a later-expiring short put.

Based on April 6 prices, rolling forward produces an additional net credit while also allowing you to exchange for a lower strike. Compare these prices as of April 6 on Google puts:

• May 635: 27.40
• June 630: 28.30
• September 625: 40.50

You could replace the current position by committing to one extra month at a five-point lower strike and earn an additional $90. Or if you are willing to tie yourself into four more months, you can earn another $1,310 (40.50 - 27.40) while reducing strike exposure by 10 points.

Admittedly, the short put on an expensive stock like Google presents market risks; but if you don’t want to spend over $63,000 for 100 shares of stock, you get the same market risk and a net credit with the synthetic long stock. Here is a comparison of outcomes at various underlying prices:

This summary demonstrates that the combined option positions in the synthetic long track movement in the underlying point for point; at exercise, you end up with the same profit or loss that would happen be putting out more than $63,000 for 100 shares of stock.

The Google example may not apply in every situation due to the volatility level of the stock. When it comes to options positions, volatility is the big deciding factor. However, the same rationale is easily applied to stocks at any volatility level and any price, even prices below $50 per share. Option premium won’t be as rich, but the long/short offset still enables you to benefit from price movement for little or no outlay of cash.

The volatility of the underlying and of the option affects premium value, but also defines differences in levels of risk, so the underlying you pick should be a good match for your risk tolerance. Volatility is the most important feature of options, and you can time your entry and exit based on the rapid changes in volatility levels.

This can be complex without help, but it can be simple and easy with the right tracking tools. To improve your option trade timing, check the Benzinga service Options & Volatility Edge which is designed to help you improve selection of options as well as timing of your trades.