Sunday, April 6, 2008

Synthetic Stock - inexpensive alternative to buying shares

The following is a hypothetical example that can be applied to any stock, index, ETF, etc.

Suppose you thought that MSFT has found support at 27 and therefore felt that MSFT (currently at 29) had little downside risk but decent potential upside.

You could purchase 100 shares of MSFT for $2,916.

Or you could buy an ATM call for $211 while simultaneously selling an ATM put for ($281) for a total capital outlay of negative $70. Keep in mind though that you will be required to have $940 in your account as collateral for the naked put you sold.

What this strategy does, is it frees up about $2,000 of capital while your risk/reward profile is the same whether you own the stock or the 'synthetic stock'.

This is a perfect example of leverage. Suppose MSFT climbs to $35 anytime before October 2008. You will be up $570 whether you own 100 shares or if you used the strategy of buying synthetic stock - the simultaneous purchase of a call with the selling of a put with the same strike price and expiration date. You can always reverse the strategy if you're bearish on the underlying.

Suppose MSFT stays flat in 2008. Then you break even, just as if you had owned the stock. The selling of the put (credit received) offsets the declining value of the call you bought.

Suppose MSFT breaks support at 27 and goes to 25. Then you will lose $430 just as if you had owned the stock.

You can see now that the risk/reward profiles of the two strategies are the same...except for the following two points. By using options to synthetically own stock you give up shareholder voting rights (not really a factor anyway if you own 100 shares, seeing as Mr. Gates owns 857,499,336) and you won't get paid dividends. This also is not much of a factor since you can put the $2000 to work in other option positions or in an interest-bearing account to offset (or exceed) this loss in dividends.

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