When Is a Synthetic Long Position Dangerous?
A synthetic long stock position can be very profitable over time. It can also be dangerous. This approach is typically used to mimic the purchase of a stock but at a substantial savings. One way to use this strategy is to use LEAPS, which are longer term options contracts than normal. The point is to benefit from long term appreciation of the stock price without having to tie up so much capital for years. When should you consider using this approach and when is a synthetic long position dangerous?
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What Is a Synthetic Long Option?
A common way to use this approach is buy an at-the-money call and sell an at-the-money put on a stock that you believe will rise in price. Both the call and the put have the same expiration date. Because you are not selling a call at a higher strike price with this trade you have potentially unlimited profit potential. The potential for profit with the long call is roughly the same as if one were to buy the stock and hold it until the price went up. Because you are not selling a higher-priced call to offset the cost of this strategy. You will be selling a put. This leaves you with the potential for unlimited profit if the stock keeps going up. However, it also introduces the potential for unlimited loss if the stock defies your expectations and heads down.
Do Not Use a Synthetic Long Position on a Speculative Stock
There are times when a trader will risk a call on a stock that could go down as well as up because of the potential for great profits in the case of the stock rising in price. The risk is limited to the premium paid for the call contract. Adding the sale of a put can greatly reduce the cost of doing this. However, now the risk of the trade goes way up because the naked put could end up costing a lot of money. The important part of using a synthetic long position is to pick a stock with very little possibility of falling in price. Such stocks typically do not rocket up in price but rather go up gradually.
Using LEAPS for a Synthetic Long Position
LEAPS stands for long term equity anticipation securities. These are options contracts with longer than usual time until expiration. They commonly are for three years. The point of a LEAPS is to profit from long term stock price appreciation. The problems with this approach are two. The premium for such a long term option is higher than for a standard option. And you are tying up your money for three years instead of days, weeks, or even a month or two. Using the synthetic long approach helps reduce the cost of tying up money for two or three years in a LEAPS options trade.
Choosing the Right Stock Is Important for a Synthetic Long Stock Position
At Top Gun Options we have used the synthetic long stock position for Amazon.com. This stock has the potential for long term growth even though it has become a large company with multiple business niches. Like other tech companies, it was hurt by the Fed raising interest rates but is back on the rise. It is dominant in all of the sectors where it does business. Baring a horrific black swan event, Amazon.com may well go up in price virtually forever. It is a good choice for a synthetic long stock position. That having been said, we need to trade the market that we have and not the one that we want. When entering into potentially risky trades even when they have huge potential it is wise to work with a dedicated squadron of traders such as at Top Gun Options. Here we potentially make money in all markets whether they are headed up, going down, or trading sideways. Consider signing up with one of the trading squadrons at Top Gun Options.
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Originally published at https://topgunoptions.com on August 15, 2023.
