Have You Ever Thought of Using a Synthetic?

By Len Yates – President, OptionVue Systems International.

Did you know there is an option strategy – involving just two options – that behaves exactly like a position in the underlying?  It’s called a synthetic, because you’re “synthesizing” a unit of the underlying.

A synthetic is constructed by buying a call and selling a put of the same strike and duration (to go long), or buying a put and selling a call of the same strike and duration (to go short).

Since synthetic performs exactly the same as being long or short the underlying, the question naturally arises:  Why do a position with two transactions when you can do it with one?  Well, the fact is that when you're dealing with stock options, the capital requirements for a synthetic can be a whole lot less than going long or short the stock, even when using maximum margin (50%) on the stock.

For example, to purchase 100 shares of Alcoa Inc (Symbol: AA) at the current price of 37.36 would cost $3,736 cash, or $1,868 collateral on 50% margin.  To buy an at-the-money synthetic would cost $230 cash, plus $683 collateral, for a net total of $913.  Not only is this a considerable difference in collateral, the cash flow difference means that with the synthetic you get to keep your cash (all but $230 of it) and use it to earn interest.

You're probably thinking there must be a catch.  Is the synthetic riskier?  Actually, since the synthetic delivers exactly the same performance as a position in the underlying itself, there is no additional risk in using a synthetic. 

There are just two minor “catches”.  One is the fact that with a synthetic, you miss out on any dividend income.  The other is the possibility of early assignment if the short leg goes deep in the money.  Early assignment is especially likely with a short deep in the money put.  If this happens, you will suddenly be long the stock (instead of short a put) plus long a call option.  Since the long call option is far out of the money at this point, it is low priced as has very little delta.  So you are essentially just long stock, which is the same in its performance as the original synthetic.  Thus you are not exposed to any sudden risk and there is no urgency to respond immediately in some way following assignment.  Also the cash flows of the assignment itself do not create a loss for you (nor a gain).  The only difference is that your collateral requirement jumps up, as you now own the stock.

The illustration shows a synthetic long as compared to a long stock position.  The two lines are very close together.  The line for the synthetic runs just beneath the line for the long stock position because of the slightly higher transaction costs of the synthetic.

Another advantage of synthetics is that you can use them with assets where there is no tradable underlying -- such as indexes.

* Option strategies carry inherent risk of large potential losses. As such, these strategies may not be suited to every investor.