Investing > Synthetic Long Explained

Synthetic Long Explained

With a synthetic long, traders on a tight budget can get the high returns of owning expensive growth stocks. 

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Updated April 21, 2021

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Would you spend a ton of cash on an expensive cashmere sweater, when a much cheaper polyester version is just as soft, warm, and stylish?

We can apply the same question to the world of stocks. ✅ 

Lucrative growth stocks are expensive, which makes investing in them a challenge, especially for people still out of work due to the COVID-19 pandemic. Thankfully there’s an alternative. 

With a synthetic long position, a trader combines options to create a formula that offers the same profit potential as owning the underlying stock but for a fraction of the cost. In other words, traders on a tight budget don’t have to miss an opportunity to grow their wealth. 

Although the synthetic long has many advantages, it carries a lot of risk. So, in order to not go broke, you should also take the time to understand what these risks are and how to mitigate them. 

In the following guide, we’ll explain what a synthetic long position is and how it works before addressing its advantages, risks, and profit/loss profile. Then we’ll examine the synthetic long position in context of a specific example before overviewing alternative positions and helpful tips.  

What you’ll learn
  • What is a Synthetic Position?
  • Understanding the Synthetic Long
  • Advantages and Risks
  • Profit/Loss Profile
  • Synthetic Long Example
  • Hedging in a Synthetic Long
  • Synthetic Long Alternatives
  • Tips for Synthetic Longs
  • Conclusion
  • Get Started with a Broker

What is a Synthetic Position? 🔎

What do securities traders have in common with trekkies and 80s pop musicians? They know the importance of synths. While most people associate synthetic with fake, synthetic is simply an arrangement of various things to mimic another thing—like a human, instrument, or investment, and there is nothing fake about a trader’s profits and losses.  

In finance, there are various types of synthetic positions, which are combinations of options contracts and/or stocks. Depending on the combination, the position will resemble the profit/loss profile of a single option or stock position. 

Before getting into the details, it is helpful to review a bit of the jargon (or we can call it lingo to sound a little less 🤓). When an option is long, it means the trader purchased the option. When an option is short, the trader sold the option. 

Synthetic PositionCombination
Synthetic Long StockLong Call + Short Put
Synthetic Short StockShort Call + Long Put
Synthetic Long CallLong Stock + Long Put
Synthetic Short CallShort Stock + Short Put
Synthetic Long PutLong Call + Short Stock
Synthetic Short PutShort Call + Long Stock

A synthetic long position is a combination of a long call and a short put with the same strike price and expiration date. Together, the options have a profit/loss profile equivalent to owning 100 shares of a stock. 

Voila— you’re an alchemist of options. Now let’s examine how this concoction works.

Understanding the Synthetic Long 💡

When creating a synthetic long, traders will want to understand the option chain, which looks less like a wreath of daisies than a formidable wall of numbers. But don’t let the option chain’s configuration intimidate you. 

Typically, the expiration date is at the top of the option chain and the strike price is the column in the middle, with call options to the left and put options to the right. Traders will notice that in order for a call and a put to have the same strike price, which is necessary for creating a synthetic long, one of the options will be at-the-money (ATM) or in-the-money (ITM).

Option chain for TQQQ
Option chain for TQQQ: Calls with a strike price of 105 or less are ITM, while puts with a strike price of 106 or more are ITM.

When deciding on the strike price for the synthetic long, traders will usually choose the one that is ATM. In the case of a synth long on TQQQ, which is selling near $105.73/share, a trader might choose the strike price of $105 or $106. 

The strike price also influences the cost of opening the position. Since buying a call requires paying a premium and selling a put entails collecting a premium–and since the premiums are rarely equally priced–a trader will often open a synthetic long with a debit or credit. 

Credit/Debit 💳

Since premiums for ATM calls and puts are close in range but not equal in value, a trader who opens a synthetic long might choose the strike price that will give them a credit, decreasing the cost of opening the position. 

A trader will usually get a credit if the purchased call option is out-of-the-money (OTM) and has a lower premium than the sold, ATM/ITM put option. Likewise, a trader opens the position with a debit if the premium paid is greater than the premium received. 

Credit debit on synthetic long
When a stock price is less than the strike price, traders opening a synthetic long usually receive a credit, while the reverse is true when the stock price is greater than the strike price.

To understand exactly how the combination of options mimics the profit/loss profile of the underlying stock, we might try recalling the mantra of the Tri-Delts: “Delta, Delta, Delta, can I help you, help you, help you?” But if you’re thinking, “It’s all Greek to me,” don’t worry. 

A trader just needs to know the delta helps a synthetic long function like 100 shares of stock. In other words, if a stock goes up a dollar, the synthetic long position will increase in value by $100. For this reason, traders who perform fundamental analysis on the underlying stock might have a better chance of profiting from their synthetic position.

Synthetic Long Advantages and Risks ⚖️

The synthetic long is cost-efficient and has unlimited profit potential, especially when the economy soars before high inflation.  A trader can also exit a synthetic long position more easily than they can sell stock, and the exit is immediate. However, the position also carries the risk of a long call and, more significantly, short put. 

Cost and Collateral Requirements 👇

How is the synth cost-effective? For one, options are cheaper than stocks, which makes day trading using options more affordable than day trading stocks. 

Consider Tesla (TSLA). Priced at $738, buying 100 shares would require a fortune. If purchasing the shares on margin, an investor would need, depending on the broker, 50% or more of the total cost, which would be nearly $40,000. 

Buying TSLA options, on the other hand, requires significantly less capital. Depending on its expiration date (often called expiry), an ATM option for a stock priced in the $700s could range anywhere from $1,000 to $30,000.

Even though a trader will have a collateral margin requirement for the short put, the margin requirements for the top options brokers is typically 20% of the stock price. To meet collateral requirements, a trader might also need to include the put premium and the difference between the put’s strike and stock price. If the put is out of the money, the difference between the strike and stock price is subtracted from the collateral requirement. 

Imagine the trader who opened a synth long on Tesla. If the long put was out of the money by $3 and had a strike price of $740, a trader would need about $14,800 rather than $40,000 for collateral. 

Because option trading is cost efficient, a trader has more leverage and can also receive a higher return on their investment. However, the collateral requirements illustrate that even though trading options is less expensive than trading stocks, it is still expensive.

In addition to analysing the technicals of the underlying stock, a trader might also note the observations of market specialists George M. Jabbour and Philip H. Budwick. In The Options Trader Handbook: Strategies and Trade Adjustments, they write, “Keep in mind, though, that leverage makes good results very good and bad results very bad.”

In this context, a person might find it unsettling but unsurprising that the Fed subsidizes hedge funds’ massive losses with low-interest rates. The losses of the individual trader won’t be subsidized, which is why it is important for traders to understand the risk of the synth long. Although the risk is not unlimited, it can be substantial—equivalent to the fortune needed to buy 100 shares in the first place.

Profit/Loss Profile ✅

Profit 📈

The probability of synthetic long turning a profit is about 50% and requires one of the following conditions: 

  • Stock price > strike price – credit 
  • Stock price > strike price + debit

Breakeven 😐

How synthetic long positions break even: 

  • Stock price = strike price – credit
  • Stock price = strike price + debit

Loss 📉

The probability of synthetic long incurring loss is about 50%. Circumstances for loss include: 

  • Stock price < strike price – debit

Maximum Loss 🚨

How to calculate maximum loss:

  • Strike price – credit x 100
  • Strike price + debit x 100

Synthetic Long Example 📏

Let’s take a closer look at the trader with a synthetic long on Tesla. In our scenario, to open the combo position, they bought one call and sold one put, both with a strike price of 740 and an expiry of May 21. 

Since the trader opened the position, the stock gained more than 22 points, causing the price to go from $737.99 to $760.64, earning the options trader more than $2,000. Hooray! 

The computer will have a more accurate calculation that accounts for various factors such as implied volatility and time decay, but we can get a basic understanding of how profits are calculated with the following equation:  

$760.64 – $737.89= 22.75 x 100= 2,275 +/- credit/debit/commissions 

Had TSLA’s price fallen more than 22 points, instead of being more than $2,000 up, the trader would be more than $2,000 down. But imagine TSLA had fallen to $680, which is more than the amount of short put’s premium below the strike price, causing the option to be exercised. 

Our fictional trader would be not so fictionally peeved because they’d have to spend $74,000 on shares that are only worth $68,000. But, instead of losing $74,000 on unwanted and undervalued shares, the trader might decide to sell the shares and mitigate their loss to $6,000. 

$74,000 – $68,000= $6,000

The above example is not so bad compared to what might happen if, instead of seeing a 60-point drop, the trader saw an allusive black swan—not the actual bird or the Natalie Portman movie, but the rare and unpredictable event with dire consequences. (No, we’re still not talking about the Portman movie). 

How to Hedge in a Synthetic Long? 📉

The number of events that could turn a winning position into a losing position requires understanding how day trading works. A key aspect of this is knowing how to hedge bets. To limit the risk of a synth long, traders might create a collar. 

But don’t go out and purchase a studded leather choker or dress shirt just yet. The collar in this context is a protective put.  

To understand how the protective put works, pretend Elon Musk resigned because he was unable to perform his job from Mars. As a result, TSLA fell like an asteroid to earth. What could the synth long trader do to hedge their seemingly astronomical loss? Buy a put option

The long put will likely be expensive, but not as expensive as doing nothing, especially if the stock were to fall near zero. After our hypothetical trader covered their put by paying $74,000 for shares with a market value of $50 ($0.50/share), they could then sell those shares at the strike price of the long put, hedging losses by tens of thousands dollars.

Many traders prefer to buy the protective put before an asteroid or black swan has the chance to decimate their position. In the real world, where automated ETFs dominate the market and algorithms predict massive sell offs, a trader who doesn’t hedge their bet until the first sign of disaster might be too late.

Depending on the broker, a trader can buy the protective put by adding an option leg when creating their synthetic long position. To reduce costs, the long put should have a strike price that is significantly OTM, although this also depends on a trader’s specific goals and loss threshold.

Synthetic Long Alternatives 📖

The synth long is a bullish strategy that should be used cautiously. That is why traders with a limited tolerance for risk might want to try a synthetic long alternative—and here is what some of these similar, yet different strategies are.

Synthetic Long Stock Split Strikes ⚡️

When a trader opens a synthetic long position with split strikes, they buy a call and sell a put with the same expiration date but different strike prices, both OTM. With this strategy, in order to get significant returns, the stock price will need more upward movement than a regular synthetic long, but the stock price can fall a bit more before the short put is ITM.

Long Call ☎️

A trader seeking the same profit/loss profile of 100 shares of stock but without the risk of the short put could buy a deep ITM call, but those options are expensive and less liquid. Instead, a trader might settle for a cheaper OTM call. 

In this case, if the underlying’s price moves a dollar, the option’s value will move in the same direction, but to a lesser degree. For example, using a call option might only gain six cents in value if the underlying’s price increases a dollar. 

Long calls have limited risk and unlimited profit potential. The most a trader can lose with this strategy is the premium paid for the long call. 

Another long call position is called the bull call spread. For this position, a trader buys a call option and sells a call option with a much higher strike price that is unlikely to go ITM. Although the premium received will be small, it will offset the cost of the long call. 

The potential profit is limited to the difference between the long and short strike prices minus the cost of the position. The maximum risk is the price of the spread. 

Synthetic Short Stock 🤏

Once a trader knows the concept of short selling, they can create a synthetic short. To synthetically short a stock, a trader would do the reverse of taking a synthetic long position. Instead of a long call and a short put, a trader establishes the position with a short call and long put with the same strike price and expiry. 

The benefits to the synthetic short include not having to borrow the stock or pay dividends, if the underlying issues dividends. However, while this bearish position has unlimited profit potential, it also comes with unlimited risk.

Tips for Using a Synthetic Long 🚀

Just as the distance between the stock price and strike price affects the cost of options, news and other events can affect costs, which can significantly help or hurt a trader’s synthetic long strategy.  

Consider how earnings reports often play a big role in the price of stock. Entering a synthetic long position just before the report comes out could have terrible results, unless the trader is near certain how the statement will influence investors. 

Similarly, dividend announcements can influence stock and option prices, so when there is a dividend bull run, traders will want to pay close attention. Dividends can influence a synth long despite the position being ineligible to receive dividends. 

In other words, if a company announces they’ll be issuing dividends, the stock price will be expected to dip since the company will be paying shareholders rather than investing in growth. In this case, put options will usually cost more than call options, but ITM long calls have a higher chance of being exercised.

Conclusion 🏁

Learning how to trade options is not easy, so you’re nothing short of a rockstar if you understand what a synthetic long position is and how it works. Synthetic positions are more challenging than simple option trading because they combine options and/or stocks. But oftentimes, the more challenging option comes with its own rewards.

Sure, as long as a trader has the money, buying 100 shares of stock is easy. However, if they chose to open a synthetic long position instead, they need significantly less money without having to sacrifice the potential of unlimited profit. 

Of course there are risks, but risks can be hedged by purchasing a put. Traders can think of this hedge like popping the collar out from under their polyester sweater. It’s a smart look.  

Synthetic Long FAQs

  • What are Synthetic Options?

    A synthetic option is a combination of a stock and an option in order to resemble the profit/loss profile of a single option. Depending on which position is taken, synthetic positions can require less capital but equally significant returns as their non-synthetic (authentic) counterpart. 

  • What is a Synthetic Hedge?

    Synthetic hedges are used by futures traders and, like other synthetic positions, are created by combining various options. To create a synthetic futures forward contract, a trader combines a short call and a long put.

  • Is Options Trading Profitable?

    Trading options can be profitable, particularly if a trader is experienced and skilled at managing their risk. Trading options can also be very costly with unlimited risk.

  • How Do You Avoid Losses in Options Trading?

    Option traders cannot avoid incurring some loss. To limit their losses, they use various risk management strategies. 

Get Started with a Broker

And there you have it! If you’re utilizing complex financial instruments like synthetic longs, you need to leverage a reliable broker.

Fees
Minimum initial deposit

$0

TS Select: $2,000

TS GO: $0

Commissions

Vary

$0

Account minimum

$0

$0

General
Highlight

Huge discounts for high-volume trading

Powerful tools for professionals

Best for

Active traders

Active options and penny stock trading

Promotion
Rating
Fees
Minimum initial deposit

TS Select: $2,000

TS GO: $0

$0

Commissions

$0

$0

Account minimum

$0

$500

General
Highlight

Powerful tools for professionals

Low fees

Best for

Active options and penny stock trading

Beginners and mutual fund investors

Promotion
Rating
Fees

Minimum initial deposit

$0

TS Select: $2,000

TS GO: $0

$0

Commissions

Vary

$0

$0

Account minimum

$0

$0

$500

General

Highlight

Huge discounts for high-volume trading

Powerful tools for professionals

Low fees

Best for

Active traders

Active options and penny stock trading

Beginners and mutual fund investors

Promotion

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

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