Leveraging 100 Shares of Stock for Little or No Cost
Synthetic long stock strategies track the price movement of 100 shares of stock, but tracking volatility is key.
How is this possible?
The "synthetic long stock" position has two sides. First is a long call, second is a short put. The cost of the call is mostly or entirely covered by income you receive for selling the put. However, as the stock price changes, the combined synthetic value duplicates that price movement. As long as the stock price is higher than the strike of the options, this movement goes point for point.
You expect the stock to rise, which is why this position is called synthetic long stock. But what happens if the price of the stock falls? In that case, the short put is going to increase in value and you risk having it exercised at a loss. In other words, you face the same risk you face by owning 100 shares. An important distinction: When you put out the cash for 100 shares, a loss is unavoidable if the price falls. But when you have a short put, you can avoid that loss completely even as the price of the stock falls. You can close the position, often at a profit or breakeven (due to falling time value). You can cover it by buying a long put expiring later. Or you can roll the put forward to avoid or delay exercise.
Here is an example of a synthetic long stock position: At the open on April 6, Johnson & Johnson (JNJ) was bid at $65.00 per share. The July 65 call was at 1.68 and the July 65 put was at 1.80. If you bought the call and sold the put, the net credit would have been 0.12 -- which is very close to covering transaction costs for opening this two-part position. So assuming your actual net is about zero, how would the value of a synthetic long stock position move at various changes in the underlying stock?
Note that the difference in the net synthetic stock position is 0.12, the same as the net credit between the long call and the short put. This demonstrates that by buying the call and selling the put, the combined position acts just like 100 shares of stock in both directions -- but the position costs close to zero.
The strategy allows you to create a low-cost or no-cost position that tracks the price movement of 100 shares of stock. But because part of the position includes an uncovered put, it is essential to develop the means for excellent timing for both entry and exit. In the options world, that means tracking volatility. For options traders, the key to the timing of trades is as important as picking the right stock and strike. To make this simple and easy, check Volatility Edge for ideas on how to find synthetic long stock and other options-based positions.
About the author: Michael C. Thomsett is an author with six options books published, including the best-selling Getting Started in Options (Wiley, over 250,000 copies sold in eight editions), and Options Trading for the Conservative Investor (FT Press, now in its second edition). The author is also the Chief Education Officer of conservativetrade.com -- a website devoted to helping traders pick high-probability options trades in a conservative trading program. Thomsett's website is www.michaelthomsett.com.
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