Synthetic Long Stock Explained

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Contents

Synthetic

What is Synthetic?

Synthetic is the term given to financial instruments that are engineered to simulate other instruments while altering key characteristics. Often synthetics will offer investors tailored cash flow patterns, maturities, risk profiles and so on. Synthetic products are structured to suit the needs of the investor.

NYIF Instructor Series: Synthetic Stock

Understanding Synthetic Positions

There are many different reasons behind the creation of synthetic positions. A synthetic position, for example, may be undertaken to create the same payoff as a financial instrument using other financial instruments. A trader may chose to create a synthetic short position using options as it is easier than borrowing stock and selling it short. This also applies to long positions, as traders can mimic a long position in a stock using options without having to lay out the capital to actually purchase the stock.

Key Takeaways

  • A synthetic is an investment that is meant to imitate another investment.
  • Synthetic positions can allow traders to take a position without laying out the capital to actually buy or sell the asset.
  • Synthetic products are custom designed investments that are created for large investors.

Example of a Synthetic Position

For example, you can create a synthetic option position by purchasing a call option and simultaneously selling a put option on the same stock. If both options have the same strike price, let’s say $45, this strategy would have the same result as purchasing the underlying security at $45 when the options expire or are exercised. The call option gives the buyer the right to purchase the underlying security at the strike, and the put option obligates the seller to purchase the underlying security from the put buyer.

If the market price of the underlying security increases above the strike price, the call buyer will exercise his option to purchase the security at $45, realizing the profit. On the other hand, if the price falls below the strike, the put buyer will exercise his right to sell to the put seller who is obligated to buy the underlying security at $45. So the synthetic option position would have the same fate as a true investment in the stock, but without the capital outlay. This is, of course, a bullish trade and the bearish trade is done by reversing the two options (selling a call and buying a put).

Understanding Synthetic Cash Flows and Products

Synthetic products and more complex than synthetic positions, as they tend to be custom builds created through contracts. There are two main types of generic securities investments: those that pay income and those that pay in price appreciation. Some securities straddle a line, such as a dividend paying stock that also experiences appreciation. For most investors, a convertible bond is as synthetic as things need to get.

Convertible bonds are ideal for companies that want to issue debt at a lower rate. The goal of the issuer is to drive demand for a bond without increasing the interest rate or the amount it must pay for the debt. The attractiveness of being able to switch debt for the stock if it takes off, attracts investors that want steady income but are willing to forgo a few points of that for the potential of appreciation. Different features can be added to the convertible bond to sweeten the offer. Some convertible bonds offer principal protection. Other convertible bonds offer increased income in exchange for a lower conversion factor. These features act as incentives for bondholders.

Imagine, however, that is an institutional investor that wants a convertible bond for a company that has never issued one. To fulfill this market demand, investment bankers work directly with the institutional investor to create a synthetic convertible purchasing the parts – in this case bonds and a long-term call option – to fit the specific characteristics that the institutional investor wants. Most synthetic products are composed of a bond or fixed income product, to safeguard the principal investment, and an equity component, to achieve alpha.

The Rabbit Hole of Synthetic Creations

Products used for synthetic products can be assets or derivatives, but synthetic products themselves are inherently derivatives. That is, the cash flows they produce are derived from other assets. There’s even an asset class known as synthetic derivatives. These are the securities that are reverse engineered to follow the cash flows of a single security.

Synthetic products get far more complex than synthetic convertibles or positions. Synthetic CDOs, for example, invest in credit default swaps. The synthetic CDO itself is further split into tranches that offer different risk profiles to large investors. These products can offer significant returns, but the nature of the structure can also leave high-risk, high-return tranche holders facing contractual liabilities that are not fully valued at the time of purchase. The innovation behind synthetic products has been a boon to global finance, but events like the financial crisis of 2007-09 suggest that the creators and buyers of synthetic products are not as well-informed one would hope.

Synthetic Options Explained

One of the interesting features about options is that there is a relationship between calls, puts, and the underlying stock. And because of that relationship, some option positions are synthetic to others. The prices of put and call options have an identity relationship through the concept of put-call parity.

Some option combinations are easier, or less costly to trade than others. Which means less slippage and less commissions.

Here are few examples of synthetic options positions.

Synthetic Long Stock

Among the many options strategies, one of the most interesting is synthetic long stock . This combines a long call and a short put opened at the same strike and expiration. The name “synthetic” is derived from the fact that the two positions change in value dollar for dollar with changes in 100 shares of stock.

Synthetic Long Stock Construction
  • Buy 1 ATM Call
  • Sell 1 ATM Put

This is an unlimited profit, limited risk options trading strategy that is taken when the options trader is bullish on the underlying security but seeks a low cost alternative to purchasing the stock outright.

Synthetic Short Stock

The synthetic long stock is a low-risk, highly leverage strategy. But for synthetic short stock, the risk profile is completely different. For the synthetic long, the combination consists of a long call and a short put, at the same strike, and at the same expiration.Reversing the positions to short call and long put creates a synthetic short stock, and completely changes the risk.

Synthetic Short Stock Construction
  • Buy 1 ATM Put
  • Sell 1 ATM Call

This is a limited profit, unlimited risk options trading strategy that is taken when the options trader is bearish on the underlying security but seeks an alternative to short selling the stock.

Synthetic Long Call

A synthetic call, or synthetic long call, is an options strategy in which an investor, holding a long position in a stock, purchases an at-the-money put option on the same stock to protect against depreciation in the stock’s price. It is similar to an insurance policy.

Synthetic Long Call Construction
  • Buy 100 Shares
  • Buy 1 ATM Put

This is an unlimited profit, limited risk options trading strategy. A synthetic call is also known as a married put or protective put. The synthetic call is a bullish strategy used when the investor is concerned about potential near-term uncertainties in the stock. By owning the stock with a protective put option , the investor still receives the benefits of stock ownership, such as receiving dividends and holding the right to vote. In contrast, just owning a call option , while equally as bullish as owning the stock, does not bestow the same benefits of stock ownership.

Synthetic Long Put

By combining a long call option and a short stock position, the investor simulates a long put position. A synthetic put is also known as a married call or protective call.

Synthetic Long Put Construction
  • Sell 100 Shares
  • Buy 1 ATM Call

This is a limited profit, limited risk options trading strategy. The synthetic put is a strategy, used when the investor has a bearish bet and is concerned about potential near-term strength in the underlying stock. It is similar to an insurance policy except that the investor wants the price of the underlying stock to fall, not rise. The strategy combines the short sale of a security with a long-call position on the same security.

Other Equivalent Positions

The basic equation that describes an underlying and its options is: Owning one call option and selling one put option (with the same strike price and expiration date) is equivalent to owning 100 shares of stock. Thus,

S = C – P; where S = stock; C = call; P = put

There are some other options positions that can be considered equivalent. For example, take a look at a covered call position (long stock and short one call), or S-C.

From the equation above, S –C = -P. In other words, if you own stock and sell one call option (covered call writing) then your position is equivalent to being short one put option with the same strike and expiration. That position is naked short the put. Amazingly some brokers don’t allow all clients to sell naked puts, but they allow all to write covered calls. But as we can see, writing a covered call is equivalent to selling a naked put.

Summary

Synthetic positions can be used to change one position into another when your outlook changes. Options offer enormous flexibility in positioning. Synthetics can offer an alternative plan B, require less capital, eliminate the need to borrow the stock if selling it short etc. It is essential to understand synthetic options in order to fully utilize the flexibility of options.

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    Synthetic Long Stock (Split Strikes)

    The synthetic long stock (split strikes) is a less aggressive version of the synthetic long stock.

    The synthetic long stock (split strikes) position is created by buying slightly out-of-the-money calls and selling an equal number of slightly out-of-the-money puts of the same underlying stock and expiration date.

    Synthetic Long Stock (Split Strikes) Construction
    Buy 1 OTM Call
    Sell 1 OTM Put

    The split strike version of the synthetic long stock strategy offers some downside protection. If the trader’s outlook is wrong and the underlying stock price falls slightly, he will not suffer any loss. On the flip side, a stronger upside move is needed to produce a profit.

    Profits and losses with a split strike strategy are also not as heavy as a corresponding long stock position as the strategist has traded some potential profits for downside protection.

    Unlimited Profit Potential

    Similar to a long stock position, there is no maximum profit for the synthetic long stock (split strikes). The options trader stands to profit as long as the underlying stock price goes up.

    The formula for calculating profit is given below:

    • Maximum Profit = Unlimited
    • Profit Achieved When Price of Underlying > Strike Price of Long Call – Net Premium Received
    • Profit = Price of Underlying – Strike Price of Long Call + Net Premium Received

    Unlimited Risk

    Like the long stock position, heavy losses can occur for the synthetic long stock (split strikes) if the underlying stock price takes a dive.

    Often, a credit is taken when establishing this position. Hence, even if the underlying stock price remains unchanged on expiration date, there will still be a profit equal to the initial credt taken.

    The formula for calculating loss is given below:

    • Maximum Loss = Unlimited
    • Loss Occurs When Price of Underlying

    Breakeven Point(s)

    The underlier price at which break-even is achieved for the synthetic long stock (split strikes) position can be calculated using the following formula.

    • Breakeven Point = Strike Price of Short Put – Net Premium Received OR Strike Price of Long Call + Net Premium Paid

    Example

    Suppose XYZ stock is trading at $40 in June. An options trader setups a split-strikes synthetic long stock by selling a JUL 35 put for $100 and buying a JUL 45 call for $50. The net credit taken to enter the trade is $50.

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    Scenario #1: XYZ stock price rise moderately to $45

    If the price of XYZ stock rises to $45 on expiration date, both the long JUL 45 call and the short JUL 35 put will expire worthless and the trader keeps the initial credit of $50 as profit.

    Scenario #2: XYZ stock rallies explosively to $60

    If XYZ stock rallies and is trading at $60 on expiration in July, the short JUL 35 put will expire worthless but the long JUL 45 call expires in the money and has an intrinsic value of $1500. Including the initial credit of $50, the options trader’s profit comes to $1550. Comparatively, a corresponding long stock position would have achieved a larger profit of $2000.

    Scenario #3: XYZ stock price crashes to $20

    On expiration in July, if the price of XYZ stock has instead crashed to $20, the long JUL 45 call will expire worthless while the short JUL 35 put will expire in the money and be worth $1500. Buying back this short put will require $1500 and subtracting the initial $50 credit taken when entering the trade, the trader’s loss comes to $1450. A heavier loss of $2000 loss would have been suffered by a corresponding long stock position.

    Commissions

    For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

    However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

    Synthetic Long Stock

    There is a more aggressive version of this strategy where both the call and put options involved are at-the-money. While a smaller upside movement of the underlying stock price is required to accrue large profits, this alternative strategy provides less room for error.

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