It's no secret that buying call options is cheaper than buying a stock outright. For traders lookingto stretch their dollar even further while mimicking the risk/reward of stock ownership, there's an even better alternative: a 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.
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).
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.
Losses, however, 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.