When an options trader is certain that a stock will go up in price, a synthetic long stock option strategy is a good way to reduce the cost of locking in profits as the stock rises. The strategy has both unlimited profit potential when the stock goes up and unlimited risk potential when the stock goes down. The trade involves buying at-the-money calls and selling at-the-money puts in equal numbers. The first issue with a synthetic long stock option strategy is the accuracy of your assessment that the stock will go up in price. The second is keeping track of this trade so that you can bail out should the stock price start to fall.
What Are Synthetic Options?
This term is used to describe options strategies in which the trader mixes calls and puts, both buying and selling, to create a trade profile that will be profitable at a lower price than by simply buying a call or a put. This strategy makes sense over the long term because studies show that the vast majority of options expire worthless. That is because the stock in question does not change significantly in price. In the case of the synthetic long stock option strategy, selling the at-the-money put offsets the cost of buying the at-the-money call. Thus, much of the time, the strategy will not make any money but will be cheap to execute.
Pros and Cons of a Synthetic Long Stock Option Strategy
The attractive feature of this strategy is that it has the same unlimited profit potential as simply buying a call on the stock but for a lower cost. The most dangerous part of this strategy is that the put that you sell has potentially unlimited downside risk. This is typically not a trade that you will set up for a stock in a volatile market but rather one that you will use for stock that is on a steady rise. Because many stocks in a bull market go up, drop due to profit taking, and then go up again, this strategy is often used on the dip to benefit from the next rise in price.
Profit or Loss From a Synthetic Stock Option Strategy
When you buy an at-the-money call, you purchase the right to buy the stock for the strike price of the option contract. You will be able to do this up until the date of expiration of the contract no matter how high the stock price might rise. If a stock rises significantly, a purchased call can be extremely profitable. Traders may choose to buy the stock but will more commonly exit the contract for a profit. Because the profit side of this trade is its purchased call, the profit potential is theoretically unlimited. The potential loss from this strategy comes with the put that you sell. By selling the put you offset part or all of the cost of buying your call. When your assessment of how the stock will trade is correct, the price will stay the same or rise. But, if your assessment is wrong, the stock will fall in price. The purchaser of the contract may execute it which means you need to buy the stock at the strike price but can only sell it at the now-lower market price. If the stock price is in free fall, you need to exit the contract at a loss before your losses become even greater.
Picking the right stock and accurately predicting price movement are essential to making this strategy work. By working with Top Gun Options, this is one of the skills that you will develop.