Know Your Options, Part 3

Before you dive into this article, take a minute to look back at the first two in the series. In part one, I reviewed some option terminology and tried to instill fear into those seduced by the promise of oversized returns. In part two, I introduced the short put as a lower-risk option strategy for owning small caps that have tradable options. To summarize: The upside is owning a quality company, ideally at a fetching price. The downside is being left with nothing but cash as a reminder of a company loved and lost.

This article is the final piece of the options puzzle (for now): the synthetic long stock position. It's the best way I know to marry investing (not speculation) and options.

Go synthetically long
The synthetic long stock position is so named because the payoffs and risks versus straight stock ownership are the same, only amplified. To set up a synthetic long, you sell a put option and use the proceeds to purchase a call option.

Let's use 3M (NYSE: MMM  ) as an example. Consider the profit table below comparing stock ownership versus a synthetic long position. (As of this writing, the stock sells for $72 per share, while January 2008 calls and puts with a $75 strike price sell for $9 each.)

Stock Price
at Expiry

Stock
Profit (Loss)

Long Call
Profit (Loss)

Short Put
Profit (Loss)

Synthetic Long
Profit (Loss)

$60

($12)

n/a

($15)

($15)

$70

($2)

n/a

($5)

($5)

$80

$8

$5

n/a

$5

$90

$18

$15

n/a

$15

$100

$28

$25

n/a

$25

The only difference between the profits of the stock purchase and the synthetic long purchase is the $3 difference between today's share price and the $75 strike price. So why not just purchase stock?

Good question. A synthetic long is a way of introducing some leverage to your account and thereby potentially supercharging your returns with money that is not actually yours. I view personal account leverage like corporate debt: Taking on a little at an opportune time, as Middleby (Nasdaq: MIDD  ) did when it purchased and retired the shares of the former chairman and his family, can be a good thing, but too much -- a la Krispy Kreme (NYSE: KKD  ) -- can rapidly derail an enterprise.

"Opportune time" is, of course, the key phrase in that last sentence. 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 buying a good business at a great price.

If we assume that 3M fits these criteria, let's compare the purchase of 100 shares at $72 versus setting up a leveraged synthetic long at a strike price of $75.

To calculate the collateral cost of setting up the synthetic long, add 20% of the value of 100 shares ($72*100*0.2 = $1,440) to the put premium ($9*100 = $900) and the difference between the stock price and strike price (($75-$72)*100 = $300). Then add/subtract the debit/credit between the put and call prices, which in this case is zero. So your net collateral in this scenario is $2,640.

Thus, for $2,640, we have action on $7,200 worth of stock. And as you can see, that leverage will amplify returns in both directions:

Stock Price
at Expiry

Stock
Profit (Loss)

Synthetic Long
Profit (Loss)

$60

(16.7%)

(56.8%)

$70

(2.8%)

(18.9%)

$80

11.1%

18.9%

$90

25.0%

56.8%

$100

38.9%

94.7%

Identify promising synthetic longs
If you decide to head down this road, it pays to spend a lot of time researching candidates. I think that 3M -- given its low relative historical valuation, steadily improving margins and cash management, strong free cash flow generation, and my estimated margin of safety of 15-22% -- is a good choice for a synthetic long. However, companies such as Research In Motion (Nasdaq: RIMM  ) , with its very high valuation on both a relative and discounted cash flow basis, or Integra LifeSciences (Nasdaq: IART  ) , with its prospects for outsized risks and rewards, would both be risky candidates for a synthetic long strategy.

In fact, the best candidates for a synthetic long are likely beaten-down stalwarts such as those recommended by Philip Durell at Motley Fool Inside Value. After all, he recommended 3M to subscribers back in July.

What can go wrong
First and foremost, half of this strategy is going short a put. So be aware that, if the stock falls significantly from your buy price, the holder of the put may choose early exercise, and you'll be buying shares. Since this is a leverage strategy, you'll have to find some money quickly, or your broker will do it for you -- not a pleasant experience.

If the underlying company pays a fat dividend, the synthetic long holder, who controls only options on the stock, will not receive that dividend.

Finally, with options, time is your friend. You want lots of time for your investment thesis to play out. It's my opinion that synthetic longs are not well-suited for short-term situations. Currently, the longest-term tradable options are January 2008 LEAPS (Long-Term Equity Anticipation Securities), which offer more than two years for your thesis to play out. Without that much time, I'd forgo the synthetic long on an undervalued company and 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
It's worth noting that the short put and the long call that make up the synthetic long are linked only in the mind of the investor. The market cares not a whit that you hold both positions. If the stock rises substantially, you might consider selling a portion of the call option, which will have risen in value, and buying back the put option, which will have fallen in value. The risk of the total position is greatly reduced in such a circumstance.

Again, my caveat is that Fools should be stock investors first. Learning to identify promising investments and value underlying businesses is far more worthy of your time than is 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.

Tom Gardner originally recommended Middleby in the November 2003 issue ofMotley Fool Hidden Gems,and it has since risen 274.6%, versus 14.13% for the S&P 500. For more market-beating small-cap recommendations, try Hidden Gems free for 30 days.

Jim Gillies has a synthetic long position in 3M. He's run out of humorous things to say here, so feel free to take potshots at him. Krispy Kreme and Integra LifeSciences are Stock Advisor recommendations; 3M is an Inside Value pick. The Fool has a disclosure policy.


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