Options Education: Understanding Synthetic Stock

trading options“I just want to say one word to you, just one word, synthetics”

Obviously this is play on the famous quote from that fine old movie, The Graduate. The actual word Benjamin is told was “plastics”, but it’s a way of introducing what I do want to talk about today, and that’s synthetics. Particularly synthetic stock, both long and short. One can create synthetic puts and calls as well as synthetic futures, but that’s a subject for another day.

Synthetic stock, both long and short, has exactly the same profit and loss characteristics as regular stock yet with much greater leverage. Synthetic stock on the long side is created by being long the call and short the put with the same expiration price. A good reason to use synthetic stock is named above, leverage. In other words, a way to own the stock more affordably. Take Google (GOOG) for instance. At 887.50 (price as of May 14) it is a very pricey stock. Instead of buying, say, 200 shares which ties up $177,500, you can create 200 shares synthetically by buying 2 June 880 calls at 21 and selling 2 June 880 puts at 13.50.

This is exactly the same as buying the stock at 887.50 except now you are only spending $1500. You will have to margin the short put but that margin can be in the form of an interest bearing asset such as a T Bill. To review, long call, short put (same strike) = long stock.

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Let’s move on to synthetic short stock. Synthetic stock on the short side is created by being long the put and short the call with the same expiration price. Not every private investor has the facility to borrow shares and sell them short in the market. Borrowing stock also means incurring extra costs in the form of lending fees.

Let’s take a different stock as an example, Apple (AAPL), currently trading at 445. You can buy the June 450 put at 17 and sell the June 450 call at 12. This position has exactly the same profit/loss characteristics as being short the stock at 445. Remember, synthetic short stock = long put, short call.

Just another example of the many and varied ways to use options. So, if I can say just one word, just one word, that word is synthetics.

Randall Liss is the author of The Liss Report.

Twitter: @RandallLiss

Author holds no position in any securities mentioned at the time of publication.

Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of any other person or entity.