While we all know that trading options provides unbeatable leverage and potential returns that straight buy-and-hold investors can only dream about, sometimes simply buying a call or a put option is only the first step to truly harnessing the power of the options markets.
It’s possible to use options to simulate a long stock position. We can also use a combination of stock and call options to replicate the returns of both long and short put options.
To complete the trifecta of embracing the enhanced risk-vs.-reward scenarios that can accompany synthetic investments, today let’s talk about creating synthetic calls.
First, let’s talk about synthetic long calls.
By buying a put option and buying the underlying stock in a 1-to-1 ratio (that is, one options contract per 100 shares of stock), you create a long call option and, thus, recreate the risk/reward scenario.
If you buy an XYZ Oct 40 Put on its own, without the long stock, then you’re looking for the stock to finish below $40 on that third Friday in October. But with a synthetic call strategy, you still buy that Oct 40 Put, but with the expectation that the stock (that you hold long) will finish above that $40 strike price.
So, why not just buy an Oct 40 Call if you’re bullish on the stock? You could, but with the synthetic strategy, the put actually acts as a hedge in case your share price goes down. Now, you’re actually counting on the stock to go up, just like you would as a stock investor, but the put option you also bought gives you a different way to profit.
So, you may buy the stock at $45 and spend $2.50 on that put option at the $40 strike. If the stock goes up, the put becomes worthless and you’ve spent $2.50 a share on insurance during the life of the option contract. You’d need for the stock to reach $47.50 to “break even” on the trade ($45 + $2.50) and anything higher is your profit. If the stock soars on some great news, your gains can be unlimited, like with a traditional long call.
But if the stock drops to $40, that put becomes an in-the-money option. The lower the shares drop, the deeper in-the-money the puts become. Yes, that means the long stock position becomes less valuable, but the put gives you the right to “put” your long stock to the person who is short the put at the strike price.
So, you would put your $45 stock to the option-writer at $40 a share, which caps your losses at $5 per share — and that’s your maximum loss.
Either way, as the owner of the shares, you are entitled to any dividends it may pay for as long as you are a stockholder.
Now let’s discuss the synthetic short call position.
As expected, if the opposite of a long call is a short one, then the execution of the synthetic short call is the exact opposite of the synthetic long. Thus, you would write (or short) a put in a 1-to-1 ratio as you would short the stock. Again, for each put option contract you write, you would also short 100 shares.
Just like the “real thing,” the losses that can be associated with short calls can be unlimited, particularly because you are doubly short — both with the puts as well as the underlying stock.
But before you ask why on earth anyone would put themselves in a situation where they might not only have the short puts assigned to them (that is, the long put holder might choose to put their long stock to you) but also perhaps be forced to “cover” the short stock position at a higher price, keep in mind that synthetic positions are geared toward early exercise. That is, if the position becomes profitable, there’s no reason why you have to hold it any longer than you need to in order to bank some quick gains.
This strategy works with stock options, which have American-style expiration. This means that they offer the benefit of early exercise, whereas index options have European-style exercise. That is, they can only be exercised at the end of their expiration cycle.
The goal with any short call, synthetic or otherwise, is for it to finish out-of-the-money. When you short an option, you collect premium upfront and you aspire to keep that money. When you short stock, you want to “sell high and buy low” — that is, short it at a higher price than you expect it to end up at. For instance, you sell to open the XYZ Oct 40 Put if you think the stock will trade down to $40 or lower before October options expiration.
If the stock falls to $40, the stock you shorted at $45 per share, for example, you’ve made $5 per share. When the stock drops, the short put finishes out-of-the-money and you keep that premium.
If the shares go up, not only are you at risk of buying shares at or above the price at which you shorted them to cover the short stock position, but the synthetic short call strategy functions the same as a “real” short call position.
If the shares go up in value and you’re betting on the stock staying at or below $45 and the stock trades up to $50, losses can be unlimited because a stock can keep trading up, up and away.
If you’re going to do a synthetic short call strategy, stay away from the Apples (AAPL) and Googles (GOOG) and other companies that seem to always be coming out with the newest and “coolest” products. Rather, stick with more of a stalwart company that’s either stuck in neutral or whose industry might be falling out of favor on Wall Street — one whose stock price isn’t in jeopardy of skyrocketing while you’re invested in a synthetic or an actual short call.
Big risks can provide big payoffs, but when it comes to being short, a long put option is always the safest way to go!
