Synthetics - The Benefits Of Stocks Without The Cost

Imagine possessing the ability to profit from a stock's appreciation without the large cash outlay required to actually own the shares. An option strategy known as a Synthetic provides the trader with some of the benefits of stock ownership without the capital requirement.

Creating a Synthetic long stock position via options is a strategy used by traders with a bullish to neutral outlook on the stock. Synthetic stock positions mirror the actual stocks action, however don't provide the trader the benefits of dividends, voting rights and a long term horizon.

How is a long Synthetic created?

Fortunately, it's a simple option strategy that doesn't take a Finance PhD to understand. It is simply buying a call and selling a put at the same strike, same expiration. This option tactic simulates a long stock position hence the name Synthetic Stock.

The maximum gains of such a position are unlimited, however the losses can be substantial as one can lose the strike price minus the debit paid to open the position. There is also assignment risk that sometimes happens once the Put that you sold (short put ) goes deep in the money.

This will force the trader to take on the actual long stock position by buying the shares. Due to this assignment risk, one needs to be careful creating Synthetic stocks around earning announcements or potential mergers as events like these can skew expectations regarding assignment.

Synthetics break even at call strike-net debit, or put strike-net credit depending on whether it's a long or short synthetic that was originally created.

Here is a graph showing the Net Position at expiration(courtesy of the Option Industry Council)

Option Brokers and the Option Industry Council OIC provide tools for traders to evaluate Synthetic positions. Here is a snapshot of a July 2008 Synthetic from the OIC:

Remember, you create synthetic positions when you don't want to outlay the cash to actually own the stock. The downfalls are assignment potential, not able to benefit from dividends or voting rights, and the limited time horizon.

David Goodboy is Vice President of Marketing for a New York City based multi-strategy fund.