Synthetic Long Stock
Since we know that owning and holding long stock is capital intensive, today we'll show you how you can use options as a way to go synthetically long a stock with a fraction of the capital requirement. This can be a huge advantage (if used wisely) when trading covered calls or when using stock to hedge a current options position.
Today, we've got a cool video for you that I think you're going to love because it shows you how to buy the stock at basically 1/4 of the price and capital requirement that it would cost to traditionally just go long stock, and that's using synthetic long stock with options.
Do you guys even know that you can still have the same risk-reward features of owning the stock without actually owning the underlying stock?
Since we know that owning and holding a long stock is so capital intensive, today we'll show you how you can use options as a way to synthetically go long with 1/4 the capital requirement. This is how we're going to setup this strategy with options.
First, we're going to buy an at the money call option because we're going to go long the stock and then at the same time, we're going to go across the option chain and sell one at the money put option at the same strike price, so buying a call at the same strike as we sell a put option all in the same strike price.
What's the risk in this position? Just as with a traditional long stock position, you do have unlimited risk should the stock continue to fall into expiration. We're trying to replicate a stock position, so in that case, we do have the unlimited risk that the stock does continue to fall.
As far as profit potential, because you are emulating a long stock position, you have unlimited profit potential up until the expiration of the options you traded.
This is the only caveat to the strategy, is that we can replicate almost everything with a stock position except for the fact that stock, you can hold much longer and with options, you do have a defined expiration date.
But this is also a great strategy if you want to pinpoint or target some long stock positions or short stock positions into different times of the year. How do you calculate the breakeven points? In these, it's very simple. It's your long strike price plus or minus any debit or credit that you receive on the trade.
Usually, you'll pay a net debit to enter the trade, but in some cases, if the options are trading just a little bit higher than where your strikes are, you might end up with a credit, in which case, you would take that long strike and subtract out the credit that you paid.
Let's go to our broker platform here on Thinkorswim, and we'll take a look at an example. GE is a very popular stock for people to own.
I know a lot of people own in their portfolio and just judging by today's volume, almost 37 million contracts that were traded, I’d say it’s probably still a very popular stock to trade.
It closed the day just above 204, so if we wanted to go long this stock and go long it with 100 shares, we could go ahead and buy 100 shares of GE at $2,404. If we did that, our capital requirement on this trade to go long of 100 shares would be about $2,409.
You can see that's the cost to get into this trade, $2,409 to get into this trade. That’s a lot of money to throw into just one stock in one trade. What we can do with options is we can replicate that position by using an at the money call strike and selling an at the money put strike.
In this case, we will use the 24 strikes which are right here; those are the closest strikes to where the stock is currently trading at $2,404, we’re going to buy the call option and then we’re going to go ahead and sell the corresponding put option at the same strike price.
You see in this case because our strike price is just a little bit lower than where the stock is trading, we do receive a small credit of $.10 or $10, but the key here is that we’re trading the same strike prices on both sides going long the call option and short the put option.
This gives us the same profit loss diagram as we would have if we just have the long stock. You can see that’s the same, just one upward trending line.
The key here is that when we go ahead and try to confirm this order, you can see that the cost to get into this trade is just about $7 because we receive a credit, but what our broker covers in margin is about $544.
Even though we do receive a credit to get into this trade, I don't consider that to be the investment. I consider our investment to be what the broker is holding in the margin which is $544.
When we compare this to the $2,400 that it cost to own the stock below, you can see why it costs almost 1/4 to go synthetically long GE as it does to just buy the stock outright. Using options, we’re able to get into and mimic the same risk-reward features of a stock position, but with 1/4 of the capital required to make the trade.
Some of the key takeaways from going synthetic long a stock: These are great alternatives to buying the stock outright like we said because they require such a low capital investment.
But again, don't let these smaller initial investments blind you to the massive risk that you’re taking with this strategy. By no means does the fact that you're investing upfront a smaller amount of capital mean that you have a smaller overall risk.
You still are mimicking a stock position. If tomorrow, the company goes bankrupt and goes all the way to zero, you do carry that risk through the trade, and I think that that's an important point to close out this video with.
As always, if you guys have any comments or questions, please ask them right below in the comment section on the lesson page. Until next time, happy trading!
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