Synthetic Long Stock

[Igor 10]

Traders who implement a synthetic long stock strategy are betting that the market price for an option's underlying asset will go up. The technique involves buying call options and writing (selling) an equal amount of put options for the same underlying asset. Traders who use this method enter the market at low-to-zero cost. Both the potential profit and the potential loss are unlimited when entering this type of synthetic position.

 

The Differences Between ITM, ATM and OTM for Puts and Calls

There are five ways to define the relationship between an option's strike price and the market price of its underlying asset for puts and calls. Understanding the differences between the terms is important when considering the risks involved when implementing a synthetic long stock strategy.

 

Put Options:

ITM - In The Money: The underlying asset's market price is less than option's strike price.

OTM - Out of The Money: The underlying asset's market price is more than option's strike price.

 

Call Options

ITM - In The Money: The underlying asset's market price is more than option's strike price.

OTM - Out of The Money: The underlying asset's market price is less than option's strike price.

 

Both Put and Call Options

ATM - At The Money: The underlying asset's market price equals the option's strike price.

 

How to Implement a Synthetic Long Stock Strategy (ATM)

 

 

XYZ is worth $40 (market price)

1) Trader writes (sells) a put option: XYZJan40($1)

- 100 shares of XYZ stock

- Strike Price $40 (ATM), expiring in 30 days

- Premium Cost of $1

2) Trader buys a call option: XYZJan40($1.50)

- 100 shares of XYZ stock

- Strike Price $40 (ATM), expiring in 30 days

- Premium Cost of $1.50

3) Trader pays a total of $50 in premiums to enter the market [$150 (paid for call) - $100 (received from put)]

 

Result one: XYZ hits $50

a) The put option expires worthless (OTM).

b) The call option is ITM. The trader exercises his or her right to buy 100 shares at $40, pays $4000 to the writer, and immediately sells the shares in the open market for $5000.

c) The trader makes a total profit of $950 after subtracting the premiums paid to enter the market. [$950 = $1000 (profit from call) - $50 (cost to enter market)]

 

Result two: XYZ hits $30

a) The call option expires worthless (OTM).

b) The put option is ITM. The put buyer exercises his or her right to sell 100 shares at $40. The trader pays $4000 to the put buyer and sells the 100 shares received from the buyer in the open market for $3000.

c) The trader loses a total of $1050 after adding the cost to enter the market. [$1050 = $1000 (loss from put) + $50 (cost to enter market)]

 

Advantage and Disadvantage of Implementing a Synthetic Long Stock:

 

Pluses: The upside to this type of strategy is that the investor can make unlimited profits in a bull market, since the potential growth of any underlying asset is infinite. Another advantage to this technique is that the investor can enter the market at a very low cost.

 

Minuses: The downside in using a synthetic long stock strategy is when the underlying asset's market value falls. When this happens, the trader's loss risk becomes unlimited, as an asset's market price can decline to a zero value.