Wednesday, 8th September 2010

Synthetic Longs

Written by George Traganidas Topics: Articles, Options, Wealth Building

Fool.com
By Jeff Fischer
August 10, 2009

Are you confident about a stock, but reluctant to pony up the cash to buy it today? A synthetic long may be just the ticket.

This option strategy works nearly the same as owning the underlying stock outright — except you don’t need to pay up front. Usually, you’ll set up a synthetic long on a stock if you foresee a strong catalyst for appreciation in the next 18 months or so. As the stock price goes up, your options gain value along with it, sometimes to a much greater degree.

In Protective Collars, we explained that when we buy options — as opposed to selling (or writing) them — we aim to profit from the option itself, rather than getting the underlying equity involved (unless it’s to our benefit). The synthetic long allows for the best of both worlds: On the options we buy in this strategy, our upside potential is unlimited; on the options we sell, the worst-case scenario is that we end up buying the underlying stock at a price of our choosing. This makes the synthetic long an especially attractive trade for bullish investors.

Buy Calls, Sell Puts

To initiate a synthetic long, you buy a call option and concurrently sell a put option on the same underlying stock or exchange-traded fund. For a true synthetic long, the calls and puts will have the same expiration date and strike price, although there are attractive variations that we’ll discuss below.

When you buy a call, you believe that the underlying stock is going to appreciate considerably over the life of your option. If it does, the call usually gains value dramatically. If the stock does not appreciate, however, your calls will move toward expiration with less and less value, finally ending with little or no value.

That is always the risk of buying options. You need to be correct by the expiration date or the option won’t maintain value, and you could lose your whole investment. This potential loss is much easier to stomach, though, if you use income from a put sale to buy your calls. This is exactly what we do to set up a synthetic long position. Let’s see an example.

Bullish on a Stock? Go Synthetic Long!

Says it’s March 2009 and you are bullish on Stock XYZ. You believe the business will be on the upswing again within 18 months, so you’d like to set up a synthetic long position to benefit.

With the shares trading around $12.50 (as of March 13), you would buy the January 2011 $12.50 call options for $3.80 per contract, and concurrently sell (or write) the January 2011 $12.50 put options for $3.50. Your net cash outlay is just $0.30 per share. Once you make these trades, if the stock begins to appreciate, both your calls and puts will start to show gains in your portfolio, in effect mirroring the stock or even outperforming it. If the stock appreciates to, say, $20 by sometime in 2010, your calls will gain 100% to 200%, and your puts will be well on their way to becoming a 100% cash gain, too.

On the flipside, let’s suppose Stock XYZ continues to suffer from soft sales, and shares drift lower to $10 or $11 for the next year or longer. In that case, your call options will slowly lose value, and your put options put you on the hook to buy shares at $12.50. Given that you paid a net $0.30 to set up your synthetic long, your net start price on the stock will be about $12.80 per share. This is the only number you’ll ultimately care about if your trade is underwater. You’re ready to buy shares at a net $12.80, and you can then hold the shares and hope for a recovery. Your synthetic long didn’t make you any money, but ideally it bought you shares of a good company.

Splitting the Strikes

Setting up a synthetic long with identical put and call strike prices near a stock’s current share price is the norm (because you’re looking to approximate a stock purchase today), but it may not be the most comfortable choice for you. For more downside protection, you may consider “splitting the strikes” as you set up a synthetic long. In this case, you still use calls and puts that expire during the same month, but you use different strike prices.

Let’s say you decide to write the January 2011 $10 put options on Stock XYZ instead of the $12.50 puts. The $10 puts pay you $2.50 per share. With that income, you can then buy the January 2011 $15 call options (instead of the $12.50 calls from the first example) for about $2.80 per share. The net cost is the same — just $0.30 per share — but you have more downside protection when you split the strike this way. If the stock declines, you don’t need to buy it until it is $10 or lower, and your net start price will be $10.30.

What do you sacrifice? You now need Stock XYZ to appreciate by a greater degree (compared to buying the $12.50 calls) by January 2011 for your call options to appreciate meaningfully or at all.

When to Close a Synthetic Long

If all goes well, the underlying shares will appreciate for you well before your options near expiration, at which point — based on the valuation of the stock and the amount of time left in your options — you should start to consider taking your profit in your call options (unless you prefer to exercise them in order to own the stock at your call’s strike price). At the same time, your put options are on the path to expire for the full cash payment.

Usually, we’ll use synthetic longs to profit from the options themselves over the course of our investing thesis — typically, around 18 months. Only rarely will we exercise the calls and turn them into a stock position if the options are successful. On the flip side, when the position works against us and we need more time for our thesis to materialize, we’ll be ready to buy the shares and hold them.

Bottom Line

When you’re bullish on a stock and want to invest without spending capital today, setting up a synthetic long position is a sensible alternative. The strategy can reward you with handsome profits on two options at once, with unlimited upside on the call options — or it nets you shares of a stock that you should be happy to buy at a lower price.

Synthetic Longs At a Glance

  • Synthetic longs are best when you’re bullish on a strong business, at least somewhat bullish on the market overall, and expect a catalyst over the next 18 months or so.
  • Typically, you should use the longest-dated LEAPs (Long-Term Equity Anticipation Securities) you can find so you’ll have the largest window of time to be proven correct; refrain from initiating short-term synthetic longs that expire in nine months or less.
  • You must be ready to buy the underlying stock if it falls below your put option’s strike price.
  • Remember the three possible outcomes with a synthetic long: (1) the stock increases and both your options make money; (2) the stock decreases enough that you’re obligated to buy it via your put options; or (3) the stock stagnates, in which case both your options may simply expire, and you’re back where you started.
  • A true synthetic long uses the same strike price and expiration date for both calls and puts; you can “split the strikes,” however, to set up a more defensive or aggressive synthetic long, depending on your preference.
  • Once your thesis has largely played out and you’ve earned money on your calls, consider taking your profit on the calls; use the underlying stock’s valuation and your option’s approaching expiration date as guides.
  • Using a synthetic long option strategy on a dividend-paying stock does not entitle you to the dividend payment.
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