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business newsThe Synthetic Call: A Staple for the Hedged Investor
By
Wayne Ferbert
Mar 14, 2011 12:30 pm
A synthetic controls downside risk while providing significant upside potential. Here's how it works.
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-- Family friend Mr. McGuire offers career advice to recent college graduate Benjamin Braddock (Dustin Hoffman) in The Graduate (1967).
Ah, plastics. They had a great run in the '60s and '70s. If Benjamin followed Mr. McGuire’s advice, he would have had made some good coin. After all, plastics became an everyday part of our lives because they were such a great synthetic.
Webster defines a synthetic as “compounds formed through a chemical process by human agency, as opposed to those of natural origin." (See -- plastics!) But the French and Greek origins for the word are really derived from words meaning "artificial" and "to put together."
Hence, the word synthetic has become an oft-used word to describe anything constructed to be an artificial replacement. It is a quite clever use of the word -- one that even Wall Street grabbed on to, in the ‘70s ironically.
Traders realized they could use options to create synthetic positions in equities they might otherwise want to buy or short. They called them synthetic puts and synthetic calls.
One of the smartest options traders I ever met once said to me: “I don’t know why anyone would ever buy a stock outright -- I’d always rather use options to create exposure to that stock -- and control my risk at the same time.” I think wiser words have never been spoken. This single quote turned me on to options investing. It has since influenced my investing style to become a hedged investor. But there are times when you might want to own an underlying stock and couple it with an option to create the same exposure as just owning the option. These are the synthetic calls and puts.
A synthetic is a staple of the hedged investor -- as it controls downside risk while providing significant upside potential. A synthetic call is when you purchase the underlying security (like say Apple (AAPL)) and purchase a put on the underlying security. This is also called a married put or a protective put strategy.
It is a synthetic call because it behaves just like purchasing an in-the-money call at the same strike price as the put. While I prefer to purchase the deep-in-the-money calls to mimic a long position, sometimes the synthetic approach has more merit. One example is when the underlying stock has a meaningful dividend. Or if you expect to hold the stock for a long time period and want the advantage of a long-term capital gain.
Let’s look at an example in a commonly traded stock: Intel (INTC). As of this morning, Intel is trading at $20.65 -- down slightly for the day. The October put at strike price of $18 is trading at $0.82. So, you can buy about 13% downside protection for six months for $0.82. You’ll collect two dividend payments over that seven-month window also -- or about $0.36.
If you bought only the October in-the-money call for Intel at the $18 strike, it would cost you about $3.25. The in-the-money portion of that is $2.65 -- meaning the extrinsic value (or time value) is $0.60. The difference between the $0.60 in time value in the ITM call and the synthetic call time value of $0.82 is $0.22. In other words, some discounted value of the dividend you would collect if you were long the stock. The dividend we’d expect to collect is around $0.36.
In this case, between the increased value of the dividend and the potential tax advantage of owning the Intel position for more than a year, I would prefer the synthetic call approach.
Let’s look at another tech stalwart -- one that doesn’t pay a dividend: Apple. This morning, Apple is trading around $353. The October $300 put option is trading at $15.75 per share. While the deep-in-the-money $300 call option for October is trading at about $70. That price is made up of $53 of in-the-money (or intrinsic) value and $17.00 of extrinsic value (ie, time value).Interesting that the call has an extra $1.25 of cost to you the investor -- but for a $350 stock, $1.25 isn’t that much. It is the interest rate effect. With the call, you are left with a material amount of cash since you can buy the Apple long exposure with only $70 per share instead of $353 per share. You can re-invest this cash for some return. In this case, $1.25 on $300 implies a 0.40% return for seven months. If you can’t get that return from your cash at your broker, you might want to consider taking the synthetic call approach.
For each downside hedged position you consider, take the time to look at both the in-the-money option positions as well as the synthetics to find the best fit for your portfolio. If you have a long-term outlook and expect to own stocks for longer than a year, I strongly suggest using the synthetic long call position.
Happy hedging!
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No positions in stocks mentioned.
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