An interesting concept is the synthetic stock strategy. This is the use of options to set up a position that acts exactly like a stock, but without having to trade in the stock. The synthetic does require collateral for a short option, but it allows you to take the same opportunity and risk profile as a stockholder, while limiting your risk exposure.

Because no stock ownership is involved in a synthetic stock position, a loss on the short side can be rolled and replaced easily. You cannot accomplish this if you are holding shares of stock, so the synthetic position is advantageous. Secondly, if you are bearish, a synthetic stock position allows you to set up a position that acts just like short stock, but without requiring you to actually go short. That is a high-risk position that can also be expensive. When you short a stock, you have to borrow stock from your broker and then sell it. As long as this short position remains open, you have to pay interest on the borrowed shares. You hope the share price declines, so shares can be bought to close at a profit. However, if share prices rise, you could end up with a high loss as well as having to repay your broker. This problem is solved with the synthetic stock strategy.

The long synthetic stock consists of a long call and short put, preferably both opened with the same strike and at-the-money. For example, on the morning of January 29, 2015, Yahoo (YHOO) was trading at $42.84 per share. At the time the bid and ask of the 42.50 options was:

Call – Bid 1.62, Ask 1.67
Put – Bid 1.29, Ask 1.32

A synthetic stock position can be opened either long or short. In both cases, one of the two options will require collateral. At the strike of 42.50, the requirement for one option will be collateral of $4,250. A synthetic solves several problems. First, it allows a bearish trader to go short without shorting stock. Second, it enables you to mirror the price movement of stock without owning shares; thus, it is a good strategy for anyone who has the funds available to cover the collateral, but does not want to take the risk of trading shares.

A long synthetic stock consists of the long call ask of 1.62, or approximately $171 debit; and a put bid of 1.29, or approximately $120. This nets out to a $51 debit overall. So with this cost ($51), a long synthetic stock position will mirror movement in the stock, and is designed to benefit the most when stock prices rise. The intrinsic value outcome at various underlying prices:

The difference between the option net values and the stock is the same as the difference between the stock price ($42.84) and the option strikes (42.50).

When reviewing intrinsic value alone (assuming the remaining value on last trading day), it is evident that the synthetic long stock position mirrors the stock price. If the underlying price rises, the long call can be closed at a profit equal to the profit gained from owing 100 shares of stock; and the short put is allowed to expire worthless. Based on the example with a net cost of $51, this would represent a net profit of $199 ($250 - $51).

If the stock price declined, the long call would be worthless and the short put would represent a loss equal to the loss you would have experienced buying 100 shares of stock. However, the synthetic position offers a significant advantage. With a loss in stock, you only have two choices: sell at a loss or wait it out hoping the price will rebound. But with the synthetic, you can roll the short put forward and replace with a later-expiring put of equal or greater value. This means you can pick any strike you want without having to be concerned with possible exercise; and you avoid exercise indefinitely if you need to continue to roll. At any time the short put is worth more than the original net cost (in this example, only $51), it can be closed at breakeven or a profit. Compared to stock ownership, this is a more advantageous strategy. In exchange for posting collateral versus buying shares, the escape from a loss position is more practical with the synthetic long stock position.

The synthetic short stock is a bearish version, and will perform best when the stock price falls. However, compared to shorting stock, the synthetic alternative is relatively inexpensive, and requires collateral in place of shorting shares. The option premiums in the Yahoo example were:

Call – Bid 1.62, Ask 1.67
Put – Bid 1.29, Ask 1.32

A synthetic short stock consists of a long put and a short call, the opposite of the long position. For example, you set up a synthetic short stock position with the following trades: Sell one 42.50 put @ 1.29, net $120; and buy one 42.50 put @ 1.67, net $176. The net cost is $56, and this compares to the net difference between stock price of $42.84 and strikes of 42.50, or $34. The outcome of the synthetic short:

In this variety, the synthetic position gains one point of intrinsic value for each point the stock declines. This duplicates the outcome of the shorted stock, but with less risk and more flexibility. The long put can be sold at a profit when the stock declines. At $40 per share, the sale price of the put is $250, adjusted by the net debit of the synthetic position of $56, for a net profit of $194.

If the stock price rises, the long put expires worthless but the short call is in the money. You have several choices when this occurs. First, you can cover the call by purchasing shares of the stock. Second, you can buy to close the call and take the loss. Third, you can roll the call forward to avoid exercise.

The synthetic short stock position performs just like shorted stock. However, you have the added flexibility of managing an uncovered short call that you cannot obtain by shorting stock. The mirroring effect of shorted stock is clearly advantageous. And, rather than borrowing shares and paying interest on those shares (short stock), you are required to deposit collateral equal to the strike of the short call.