In this discussion, we explore a strategy that mimics a long position on a stock by selling a put and buying a call at the same strike price and expiry, typically at the money. Let’s delve into the details of how this strategy operates.
Long Stock
When you purchase a Long Stock at $50, the payoff diagram looks as follows:
As anticipated, if the stock price rises above $50, the position becomes profitable, increasing in profitability as the stock price continues to rise. Conversely, if the stock falls below $50, the position incurs losses that deepen as the stock price declines.
How To Place A Synthetic Long Stock
To establish a synthetic stock position, it’s crucial to remember a fundamental principle of options trading: if two positions have identical payoff diagrams, they represent the same trade.
Thus, we need to create an options spread that mirrors the payoff (or ‘P&L’) diagram of the long stock position, effectively creating a synthetic long call.
The spread that accomplishes this involves buying an at-the-money call and selling an at-the-money put, both with the same expiration date.
The long call’s P&L diagram is illustrated below:
Additionally, here’s the payoff for the short put:
When these two positions are combined, they yield:
This outcome mirrors the payoff diagram of the Long Stock discussed earlier, confirming that it is indeed the same trade.
Advantages Of The ‘Sell Put And Buy Call’ Strategy
You might wonder why one would opt for a synthetic long stock position instead of simply purchasing the stock. Here are a couple of compelling reasons:
Lower Capital Outlay
Owning stock necessitates sufficient capital to purchase the shares. Even when buying on margin, you must deposit 50% of the purchase price with your broker.
In contrast, the margin requirements for the ‘sell put and buy call’ strategy are significantly lower, requiring less cash upfront.
Flexibility
The involvement of options provides a sophisticated trader with greater flexibility in managing the trade.
For instance, if the stock price declines, increasing the value of the short put, it can be rolled down (i.e., sold at a lower price point) or out (buying back the put and selling a put with a later expiration date).
Downsides To The ‘Sell Put And Buy Call’ Strategy
Like all options trades, there are downsides to consider when placing the synthetic version of the long call. Here are a few:
Dynamic Margin
Although the required margin is lower than that for purchased stock, the trade includes an uncovered sold put, leading your broker to recalculate your margin requirements daily. If the stock price drops significantly, you may be required to post additional margin immediately.
Increased Leverage
With a smaller capital outlay, you are exposed to the full risk profile of the stock. This means that, relative to your capital investment, you face greater risk.
This leverage can yield higher returns on your capital requirement, but it also increases your risk exposure.
About the Author: Chris Young has a mathematics degree and 18 years of finance experience. Originally from Britain, he has worked in the US and recently in Australia. His interest in options was sparked by the ‘Trading Options’ section of the Financial Times (of London). He founded epsilonoptions.com in 2012.
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