Using synthetic longs & shorts to reduce portfolio risk

This is the second article in a continuing series devoted to strategies designed to reduce portfolio risk, reduce position cost, or both. Many of these strategies involve options replacing some or all of the desired position. They are called synthetics since the shape of their risk/reward profiles are identical to that of the underlying position. Yesterday, for example, we looked at how a synthetic long call, achieved by buying the stock (or futures) plus a put option, can be used as short-term protection against event risk.

Yesterday’s focus was on risk-reduction, but today we’ll be turning our attention to cost reduction which, when you really think about it, is just another way of reducing portfolio risk (since you’re risking less money while expecting the same reward).

Let’s see how we can do that.

Synthetic longs
A synthetic long simulates the risk/reward profile of a long position. It is composed of an at-the-money (ATM) long call and an ATM short put, both with the same shelf lives (expiration dates). The reward is unlimited to the upside, just as a long stock would be. Unfortunately, the risk to the downside is just as great as with a long position, but as we’ll see in a minute, there is a way it can be mitigated in the synthetic strategy.

Let’s consider an example ripped from today’s charts. [Note: Commissions and other costs are not included in the following calculations.]

Google (GOOG) put in a local bottom on March 9th trading around $300. On that day, the June 300 call option closed at $28.40 and the June 300 put closed at $37.00. To buy 100 shares of Google on that day at $300 a share would have cost you $30,000. That’s a chunk of change for such a small position. Let’s see how much the equivalent synthetic position would have cost.

Since 100 shares of stock represents one options contract, it would have cost you ($28.40 – $37.00) x 100 = -$860 to enter the position. The negative number means that you would have actually gotten paid to take on that position. In effect, you’re saving $30,860–gloryosky! How’s that for a reduction in your cost basis?

Let’s see how you would have fared if you had closed out your position two days ago on March 26th.

Google stock closed at $404, so that means you would have made ($404 – $300) x 100 shares = $10,400 for a 35% return. Not too shabby at all.

Now let’s look at the equivalent options position. On March 26th, the call option closed at $104.75 and the put closed at $0.20 giving a profit of ($104.75 – $0.20) x 100 = $10,455. Adding in the cost of the initial credit, your total profit would be $11,315—even better than the stock position. (Actually, I find this quite interesting because the volatility has decreased quite a bit since the beginning of March and I would have expected a lower return.)

So, the choice is yours: Would you rather have spent $30,000 to go long Google or would you rather get paid $860 to reap the same reward for a similar risk? This is the major upside of the synthetic long.

But there are a couple of downsides, too. Sometimes instead of getting a net credit you’ll be paying a net debit to enter the synthetic position. That occurs when the call is more costly than the put. In this instance, you’ll need the stock to rise above the call strike price plus the debit just to break even on the trade. For example, if the price of the call and put options had been reversed in the above example, Google stock would have needed to reach $308.60 just to break even on the trade. This is the one advantage of holding the stock position instead of the synthetic.

Limiting the downside risk on the synthetic
Selling an uncovered option can be a very risky proposition. If Google had continued to slide instead of turning to the upside, the put option would have steadily increased in value while the call decreased in value. The break even point for this trade is $291.40, so you would have been protected until then, but once the stock moves below that point, you’ll start to incur a loss. You can stop this loss by doing one of two things: close the entire position or purchase a lower strike put. You can buy this lower strike put any time, but some prefer buying it when they open the synthetic position. (Buying a lower strike put and selling a higher strike put is known as a bull-put credit spread in options parlance.)

For example, let’s suppose that in addition to our synthetic long we had also bought the June 290 put at a cost of $31. Our cost basis would have swung from a net credit of $860 to a net debit of $2240—still a whole lot less than $30,000. Our break even point would now be $322.40, and that’s quite a difference. It just made the trade riskier on the upside. If we had sold out this position on March 26th, the price of the 290 put was $0.10 so that our overall profit would have been reduced to $8225—a 267% return. [(($104.75 – $0.20 + $0.10) x 100) – $2240 = $8225]

Let’s see what would have happened if this trade went in the reverse direction.

You would lose money if, at options expiration, the stock closed below $322.40. Let’s suppose it was trading at $290 at expiration. Here, all of your options would have expired worthless and you would have been out your initial investment of $2240. Had you just owned the stock, your loss would only be $1000 since you bought it at $300. In fact, you would have done better on the pure stock play even if it had dropped as far as $277.60 but below that the loss on the stock would become greater. The maximum loss for the synthetic position is capped at the initial credit of $2240.

Synthetic short positions
The synthetic short is made up of buying an ATM put and selling an ATM call, both at the same strikes and expiration dates. It’s the same as the above strategy except in reverse. Note that the risk of this position is unlimited just as in the underlying short position. In this case particularly, I would strongly recommend that you write a bear-call credit spread which involves buying a higher strike call. This would greatly reduce your loss should the trade go against you.

Discussion of Risk
While synthetic positions can reduce portfolio risk by reducing the percentage of total dollars allocated to one position, the cost of the position can increase the position risk if the initial cost is a debit. (The position won’t begin to profit until the break even point is reached.) However, if you can enter a synthetic position at a net credit as in the Google example above, you’ve effectively lowered your break even point and decreased your downside risk. Getting into a synthetic position with a net credit (or a small debit) is the best use of the strategy.

Summary
You can see that using options to simulate long and short stock (or futures) positions can be very helpful especially to investors with smaller account values who wish to participate in the movement of higher-priced stocks. Unfortunately, Berkshire-Hathaway stocks (BRK.A, BRK.B) are not optionable.

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