Generate Real Profits Synthetically

Want to establish a profitable stock position in top-dollar stocks before they go even higher?

You can use options to create a stock position — a synthetic one — with the cash you currently have in your trading account and without the specter of a margin call threatening to jeopardize your trading position.

When you create a synthetic stock position, you’re simply buying to open (or selling to open) a call option while selling to open (or buying to open) a put option that share a strike price and expiration month.

Just like you can buy stock or short stock, you have the ability to simulate both long and short stock positions synthetically.

You can create a long synthetic stock position, which is a bullish endeavor just like buying a stock to hold long in your account. In this case, you would buy a call and sell its corresponding put. You can also create a short synthetic stock position by selling calls and buying the opposite puts.

By performing this strategy on a 1-to-1, call-to-put ratio, you can position yourself to take advantage of the price swings that could move the stock but with a lower cash outlay for a similar risk-vs.-reward scenario.

For instance, if ABC Company is trading in the $200 area and you predicting a terrific outlook for the stock in the coming months, you could look at the January 2010 options at the $200 strike price. A synthetic long position would end up with a $3 cost per share, or $300 per contract, to represent a 100-share position in the underlying stock.

Here’s how that would work. You would:

Buy 1 ABC January 230 Call at $20, Sell 1 ABC January 230 Put at $17

The $20 for the long call is money you would spend, while you would collect a $17 credit for the short put, for a total cash outlay of $3. So for $300 per contract, you’re controlling 100 shares for just a little more than the cost of a single share of the underlying stock!

If you’re accustomed to buying long calls, you typically buy those with the expectation that the stock will rise — or continue to rise — above the strike price. But the advantage of having the short put position is to offset your initial cash outlay.

Whether the stock goes up or down, both sides of this trade will travel in tandem. If the stock goes up, the call option will move in-the-money and be valuable on its own. The put will decrease in value, where you can buy it back without giving up all premium you collected at the outset of the trade.

It would be ideal if put you sold at $17 expired worthless, but if you do have to buy it back, it would hurt a lot less if you only had to pay back a fraction of that — especially if that call you bought at $20 keeps increasing in value. That’s what can make synthetic stock positions a win-win situation!

As with all stock and option trading strategies, there are risks. If the stock drops dramatically, you would need to buy back the short position, possibly at a higher premium than you collected for it, and the value of the call will drop as well. (Remember that both call-buying and put-selling, the strategies you used to initiate this trade, are both bullish bets that bank on the stock value increasing during your options’ lifespan.)

With any short position, the risk of “assignment” comes into play. In the case of the short put, someone who owns the long put could exercise his or her right to sell (or “put”) shares to you at the strike price, thereby turning your synthetic stock position into an actual one. But if you’re trading options on a stock you want to own, the trading risk of ending up with a long stock position might end up being a reward.

When you’ve got good, solid stocks that typically tend to ride their own uptrend and keep going up, options traders have a tremendous opportunity to use simulated stock positions to make very real returns!

If you enjoyed this article, check out Dawn Pennington’s “Put Real Profits in Your Account Synthetically” and “Synthetic Call Options Similar to Real Deal.”