How Conservative Bulls Can Use Options to Mimic Stock Ownership
- Posted by Andrea Kramer
- on June 22nd, 2011
The major market indexes just notched their fourth straight finish in the black, and the CBOE Market Volatility Index (VIX) — often dubbed the Street’s “fear barometer” — is on pace to end lower for the fifth consecutive session. While the recent rebound may be tempting to buyers currently on the sidelines, the more conservative crowd can gamble on an extended rally for an equity without putting a ton of capital on the line. More specifically, by employing the right options strategy, smart investors can simulate the payoff of stock ownership – but at a fraction of the cost.
Synthetic long stock positions are typically established by buying near-the-money calls and selling puts at the same strike. However, you can also establish a split-strike version of this play by simultaneously buying near-the-money calls and selling lower-strike puts with the same expiration, often resulting in a net debit. As with regular stock ownership, the objective of the strategy is for the underlying shares to power higher, increasing the intrinsic value of the purchased call and keeping the sold put out of the money. However, the beauty of the strategy is the relatively minimal risk, as the options trader stands to forfeit a lot less cash in the wake of an unexpected tumble.
Let’s make this strategy even more tangible by diving into a theoretical synthetic position on Stock XYZ, which we’ll say is currently flirting with the $45.50 level. While the fundamental, technical, and sentiment stars seem to be aligned in the bulls’ favor, we’re still concerned about any broad-market ramifications stemming from the debt drama overseas.
As such, we’re going to mimic stock ownership by purchasing the August 45 call, which was last asked at $2.42, and selling the August 43 put, which was last bid at $1.22. As a result, our position was established for a net debit of $1.20 per pair of options, or $120 total, since we now control 100 shares of XYZ. In comparison, it would’ve cost us roughly $4,550 to own that many shares outright.
In the simplest terms, our synthetic position will increase in value with each step XYZ takes north of the $46.20 level (call strike plus net debit). On the flip side, our losses will steepen with each step south of the $44.20 level (put strike + net debit) within the options’ lifetime.
Fast-forwarding to early August, let’s assume that XYZ extends its run higher on the charts, with the shares now exploring the $50 level. In this scenario, our sold 43-strike put will be worthless, while our bought 45-strike call will be worth $5, or $500 (x 100 shares). Subtracting the $120 it cost to establish the trade, our synthetic long stock position will net us $380 — more than triple our initial investment. In comparison, those who simply bought the shares at $45.50 apiece would have made $450, or about 10%, on their purchase.
On the other hand, let’s assume a flood of fiscal problems out of Europe have weighed on Wall Street, and the shares of XYZ are now slightly lower at $43.50. While this sedated price action would mean a loss of $200 for the aforementioned stock owner, a finish between the put and call strikes would cost us only $120 (our initial net debit), at most.
Finally, let’s assume that XYZ pulls back to the round-number $40 level. In this instance, the bought 45-strike call would be worthless, while it would cost us $3, or $300, to repurchase the sold 43-strike put. Adding the initial net debit of $120, our position would incur a loss of $420. Meanwhile, the stock trader’s 100 shares of XYZ would now be worth $4,000 total – netting him a steeper loss of $550.
In conclusion, by constructing this options play, bullish bettors can simulate the payoff of stock ownership without having to fork over a ton of cash. Plus, by selling puts and buying calls at different strikes, you’ve limited your risk should the equity remain between the strikes through expiration. In fact, some synthetic long stock positions are even initiated for a net credit – meaning the investor can net a small profit even amid stagnant price action.
For more options-centered educational content, or to see which stocks are heating up the options pits each day, visit my home base at SchaeffersResearch.com.
The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.blog comments powered by Disqus
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