Why You Should Know Your Options

Before diving into this article, be sure you've acquainted yourself with the four basic option strategies: long call, long put, short call, and short put. Now, what makes option investing so interesting -- and potentially profitable -- is that you're not simply stuck with those four strategies in isolation. You can combine multiple option positions with varying expirations and strike prices, along with stock ownership (or even short positions) to achieve nearly any strategic investment goal you wish. The example for today: the "synthetic long," an exciting way to marry investing and options.

Go synthetically long
The synthetic long (or synthetic long stock), is so named because the manner in which the option positions are combined offers you the same profit (or loss) opportunity as simple straight stock ownership, with a small twist: You put up far, far, less money -- perhaps none at all -- for this opportunity.

To set up a synthetic long, you first sell a put option and then use the proceeds to purchase a call option at the same strike price and expiration date. Let's use 3M (NYSE: MMM) as an example. As of this writing, the stock sells for $72, while the January 2011 $70 calls and puts sell for $9.20 and $8.70, respectively. Consider the profit table below comparing stock ownership versus a synthetic long position.

Stock Price
at Expiry

Stock
Profit (Loss)

Long Call
Profit (Loss)

Short Put
Profit (Loss)

Synthetic Long
Profit (Loss)

$50.00

($22.00)

($9.20)

($11.30)

($20.50)

$60.00

($12.00)

($9.20)

($1.30)

($10.50)

$70.00

($2.00)

($9.20)

$8.70

($0.5)

$80.00

$8.00

$0.80

$8.70

$9.50

$90.00

$18.00

$10.80

$8.70

$19.50

The only difference between the profits of the stock purchase and the synthetic long is that the option strategy is consistently $1.50 ahead of the stock purchase. That $1.50 is equal to the difference between today's stock price and the option strike ($2) less the $0.50 cost to set up the position (the difference between the cost of the call and the cash received for the put). In effect, the synthetic long is akin to buying shares at an effective price of $70.50 -- a mild discount to the market price. Is it worth it? Why not just purchase stock?

Well, synthetic longs are a leveraged strategy on the appreciation of a stock. It offers the potential to supercharge your returns with money you don't actually have. Now, I view personal account leverage like corporate debt: Taking on a little at an opportune time, as Portfolio Recovery Associates (Nasdaq: PRAA) did to take advantage of attractive prices in its core debt purchasing business, can be a good thing. But too much -- a la Select Comfort (Nasdaq: SSCS) and their ill-fated share repurchases in 2007 -- can rapidly derail an enterprise.

"Opportune time" is, of course, the key phrase. As with straight stock ownership, you need to take great care to pick your spots -- valuation matters. When setting up a synthetic long, you need to be confident that you're levering off of a good business at a great price.

Why do this again?
Assume that 3M fits the good business/great price criteria, and so compare the purchase of 100 shares at $72 versus setting up a synthetic long at the $70 strike.

To calculate the collateral cost of setting up the synthetic long, add 20% of the value of 100 shares, to the put premium, and add/subtract the difference between the stock price and strike price, and debit/credit between the put and call prices. In this scenario, your required portfolio collateral would be $2,160 per 100 shares.

Thus, for $2,160 of our assets (most of which we have tied up in other things), we have action on $7,200 worth of stock. As the stock appreciates, our gains are leveraged up. Of course, leverage cuts both ways, and the downside is similarly magnified:

Stock Price
at Expiry

Stock
Profit (Loss)

Synthetic Long
Profit (Loss)

$50.00

(30.6%)

(94.9%)

$60.00

(16.7%)

(48.6%)

$70.00

(2.8%)

(2.3%)

$80.00

11.1%

44%

$90.00

25%

90.3%

The best candidates for synthetic longs are likely beaten-down stalwarts. I think that 3M -- given its low relative historical valuation, international diversification, strong balance sheet, and robust free cash flow generation, is an intriguing choice. However, dearly valued high-flyers like Intuitive Surgical (Nasdaq: ISRG  ) , or companies in industries still reeling from the housing and credit crunch -- homebuilder Toll Brothers (NYSE: TOL  ) and banking basket-case Citigroup (NYSE: C  ) come to mind -- are probably best excluded from your "syn-long" candidates.

What can go wrong?
First and foremost, half of this strategy is writing a put. So be aware that if the stock price falls below the strike by expiry, you're going to be on the hook to honor that obligation. A falling stock price also increases the collateral required by your broker, so establish these positions in moderation, please. And potentially even worse, if the stock price falls significantly, the put owner may find it advantageous to exercise early, in which case you'll have to find some money quickly, or else your broker will do it for you -- not a pleasant experience.

If the underlying company pays a fat dividend, too bad! The synthetic-long holder controls only options on the stock, so no dividend for you!

Finally, with this strategy, time is your friend; you want lots of time for your investment thesis to play out. Synthetic longs are not well suited for short-term situations. Consider sticking to the longest-term available LEAPS (Long-Term Equity Anticipation Securities) to buy as much time as possible for your thesis to play out. If the stock you're eyeing has options going out only six months or so, forgo the synthetic long just buy the stock. Remember Ben Graham's warning that in the short term, the market is nothing more than a voting machine -- logic be damned!

The Foolish bottom line
Again, my caveat is that Fools should be stock investors first. Learning to identify promising investments and to value underlying businesses should command far more of your time than playing with options. Options are just math to supplement an investment in a business that you have already determined is worthy of your investing dollars. That said, as long as you are well diversified, open to the risks of leverage, and willing to recognize the potential rewards and risks, synthetic longs can make a fine addition to your investor's toolkit. Check out Jeff Fischer's educational series on options for additional strategies.

This article was originally published on October 12, 2005. It has been updated.

Jim Gillies owns shares of Portfolio Recovery Associates, a Motley Fool Hidden Gems recommendation. Intuitive Surgical is a Rule Breakers pick. The Fool has a disclosure policy.


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