Introduction To Synthetic Long Stock
A synthetic long stock position can be created by buying at the money call options and shorting at the money put options.The ratio of at the money call options to at the money put options is
1 : 1. Because calls increase in value when the price of the underlying security goes up and puts increase in value when the price of the underlying security goes down, the payoff diagram of a synthetic long stock resembles that of a long stock position.
A Net Debit
Executing a synthetic long stock will result in a net debit.
Advantages of synthetic long stock vs long stock
It is relatively cheaper to execute a synthetic long stock strategy than a long stock strategy as a synthetic long stock is constructed with options.
Steps
Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Bullish
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Unlimited loss potential
Step 7 : Calculating Loss on Synthetic Long Stock Strategy
Step 8 : Unlimited profit
Step 9 : Calculating Maximum Profit Of Synthetic Long Stock Strategy
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade – Executing a synthetic long stock
Step 12 : Exit Trade & Record Trade In Diary
Step 1 : Perform economic, fundamental and technical analysis
The options trader should perform economic, fundamental and technical analysis to determine the general direction of the markets and the underlying security. Some of the chart patterns the options trader should look out for are:
Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis
Step 2 : Outlook – Bullish
The trader that executes a synthetic long stock is anticipating that the price of the underlying security will increase over the life of the options. He is bullish on the price of the underlying security and the markets.
Step 3 :Study the option chain
Next, study the options chain. Select the options to be used in the creation of the synthetic long stock.
Read : Learn to read and understand options chain
Step 4 : Breakeven Analysis
The synthetic long stock has a payoff diagram with a breakeven point that has neither profit nor loss. This occurs when the straight line graph intersects the horizontal axis. This breakeven point can be calculated as:
Exercise or strike price of call + net debit
The net debit is equal to the total premium paid less the total premium received.
Step 5: Understand Your Profit Zones
Once the breakeven point has been calculated, the options trader will know where the profit zone is. The profit zone is to the right of the breakeven point.
Step 6 : Unlimited loss potential
The payoff of a synthetic long stock strategy mirrors that of a long stock strategy. As prices decline below the breakeven point, a loss occurs.
Step 7 : Calculating Loss on Synthetic Long Stock Strategy
The loss can be calculated as:
Breakeven point – price of underlying security + commissions paid to broker
Step 8 : Unlimited profit
Since the price of the underlying security can rise indefinitely, the potential for profit is really unlimited. The long call will increase in value as the price of the underlying security rises. A profit is realisable when :
Price of underlying security is greater than the sum of strike price of call and net debit
Step 9 : Calculating Maximum Profit Of Synthetic Long Stock Strategy
The maximum profit can be calculated as:
Price of the underlying security – Exercise or strike price of call/put – net debit
Step 10 : Calculate Risk & Reward Ratio
Based on possible entry and exit points, the options trader should calculate the risk and reward ratio. The trade should be attractive on a risk reward basis.
Read more : Understanding Risk/Reward Ratio For Option Traders
Step 11 : Set Up Trade – Executing a synthetic long stock
Creating a synthetic long stock involves buying at the money calls and selling out of the money puts in an equal number. The ratio of calls to puts employed is in the ratio of 1 is to 1. Hence, a trader can buy 10 at the money calls and sell 10 at the money puts on the same underlying security and he would have executed the synthetic long call.
This is to be differentiated from a synthetic long call with split strikes. In a synthetic long call with split strikes, an equal number of out of the money call are bought alongside with the simultaneous writing of out of the money puts. The term “split strikes” hence refers to options with different strike prices.
Step 12 : Exit Trade & Record Trade In Diary
Last but not least, exit the trade and record the trade’s performance in a diary for reflection and analysis. Over time, this practice will help a trader to become better.
Example Of A Synthetic Long Stock Position
WWW Corp is trading at a price of $50. A trader decides to buy 1 current month at the money call and write 1 current at the money put. As he does so, his net debit is:
$200 – $100 = $100
The call cost $200 while the put’s written premium is $100.
What the trader has just done is to establish the synthetic long stock with $100.
When the price of the underlying security goes up to $80 on expiration of the options:
| Beginning value | Ending value | Profit(+) or Loss(-) | |
| Long ATM call | $2 | $30 | +$28 |
| Short ATM put | $1 | 0 | -$1 |
| Overall profit per share | +$27 |
In this case, the profit is:
$27 x 100 = $2700
If the trader bought 100 shares of WWW Corp at $50 and sold it at $80, he would have made a profit of:
($80 – $50) x 100 = $3000
While his profit is higher in this instance of buying stock as compared to establishing a synthetic long stock, he had to fork out $5000 to buy shares. In a synthetic long stock however, his capital outlay was just $100.
If the price of WWW trades at $20 on expiration:
| Beginning value | Ending value | Profit(+) or Loss(-) | |
| Long ATM call | $2 | $0 | +$2 |
| Short ATM put | $1 | $30 | -$29 |
| Overall loss per share | -$27 |
His total loss would thus be :
$27 x 100 = $2700
If he had bought stock instead, his total loss would be:
($50 – $20) x 100 = $3000
As you can see in a long stock position, his loss is slightly exacerbated.
Synthetic long stock with split strikes
If a trader were more conservative and is willing to trade potential profit for safety, a trader can choose to use a synthetic long stock strategy with split strikes where the options used have different strike prices.
Read : Synthetic Long stock with options of different strike prices(split strikes)
Comparisons of long call vs long stock