When you set up synthetic long or short stock, you get some incredible advantages. These are easily overlooked. Consider, though:
- The risk to a synthetic position is no greater than going long or short on stock. But the synthetic position cost is close to zero, and possibly even a net credit.
- The short stock risk is virtually eliminated using options, but allowing you to play bear markets. Using one long put instead of shorting 100 shares of stock sets this up. The long put is going to increase in value for each point lost in the stock. Even so, the maximum loss is the cost of the put. On the upside of this, the short call represents the same risk for short sellers because in theory, the stock price could rise indefinitely. But call sellers can close the position, cover it, or roll forward. Shorting stock provides no chance to roll.
- Synthetic long stock (one long call, one short put, with the same strike) will mirror movement in the underlying stock, and works best on the way up. Synthetic short stock (one long put, one short call) will also mirror the stock’s movement, and is most profitable when the stock declines.
The point is, synthetic positions cost virtually nothing but act just like stock. And by the way, for those worried about opening short calls, imagine the advantage of synthetic short stock with a covered call (a collar). You get the downside advantages with none of the upside risks.
About this week’s Heavy Hitter
Michael C. Thomsett is a widely published options author, with six options books in print, published by John Wiley & Sons, FT Press, Amacom Books, and Traders Library. He blogs at FT Press and his website is www.MichaelThomsett.com.