Synthetic Long Stock creates an option position that can give dollar gains or losses equivalent to owning stock, but with vastly increased leverage.

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Strategy: Synthetic Long Stock

The Outlook: Bullish.

The Trade: Buy call and sell put at same strike price. If you use a strike above the current stock price, you will receive a credit for the entry. If you use a strike at or below the current stock price, you will pay a debit for the entry.

Gains when: Stock rises.

Maximum Gain: Unlimited.

Loses when: Stock falls.

Maximum Loss : Limited only by stock falling to zero.

Breakeven Calculation: Usually very close to stock price at the time of entry.

Advantages compared to stock: Tremendously increased leverage, much less capital required.

Disadvantages compared to stock: Tremendously increased leverage works to the downside as well, no dividends, limited life.

Volatility: no effect.

Time: no effect.

Margin Requirement : If you maintain enough cash to buy the stock at the strike price of the short put, your broker will consider the short put to be a CSEP (cash secured equity put), with no further margin requirement. If the short put is considered "naked", then the minimum margin would be 10% of the strike price of the short put times the number of shares represented, but probably more.

Synthetic Equivalent: Long Stock.

Comments

• Synthetic Long Stock has the same profit graph as long stock, during the life of the options.

• One interesting thing about Synthetic Long Stock is that the time to expiration and the IV do not usually matter much - the overall position will be priced about the same whether you use an expiration next month or a year from now, at high IVs or low IVs. So it is to your advantage to use the longest time to expiration and give the position as much time as possible to work in your favor.

• The leverage is tremendously increased compared to stock ownership. Using the example graph, a $9 investment could turn into $999 on a ten point rise in the stock, or a return of 11,100%. But, leverage works to the downside as well. The $9 investment could turn into a $1009 loss if the stock fell $10.

• If you try to protect the downside by buying a put at a lower strike, the graph is the same as a Long Call, and you might as well use the Long Call and save commission expense.

• Synthetic Stock is a demonstration of why "Put-Call Parity" exists. Put-Call Parity means that the prices for puts and calls always have a direct relationship. If one gets out of line, arbitrageurs can step in and make risk-free trades, causing the relationship to return to normal. For instance, if it were ever possible to enter the example trade for a credit of $10, "arbs" would buy all the synthetic stock they could, and short equal amounts of the real stock at the same time. Then no matter where the stock went, they would have a $10 per share profit locked in.

• Since the Synthetic Long Stock strategy gives you a position equivalent to long stock, you might also consider writing OTM calls against the position, using the nearest expiration, in order to reduce the overall cost of the position. This creates a sort of "synthetic covered call". If the stock rises to the strike you sold, you will need to close out the synthetic long stock for a gain, since you do not actually own stock to be called out of. Also, since you do not actually own stock, your broker will not see this as a covered call with no margin requirement, but as a bull call (you own a call with a lower strike and sold a call with a higher strike).

• Just because Synthetic Long Stock exists does not mean you should ever use it instead of real stock or other bullish option strategies. Real stock has the distinct advantage of unlimited life. Synthetic Long Stock exposes you to large risk if your purchase timing is anything less than perfect.

• Having said that, Synthetic Long Stock might be an acceptable strategy for "bottom fishing" in cheap stocks. Say there is a stock that has sold off to $1 a share, but you think over time it will recover. You could enter a long-term synthetic long stock position using the $2.50 strike, for a credit of about $1.50 a share. As long as you keep your position sized such that a $1 a share loss is acceptable, you could reap very large percentage gains, with no cash invested, if the stock recovers to anywhere over $1 a share.