A synthetic long is an option strategy that replicates going long the underlying asset. The strategy is used by bullish investors who wish to use the leverage of options to establish a position at a lower capital cost.
As with going long in a particular asset, potential profits are unlimited, however, potential losses can be substantial if the underlying asset price goes to zero.
What Is a Synthetic Long?
First, a refresher on the two basic types of options: puts and calls. Options are a type of derivative that may allow investors to gain — not by owning the underlying asset and waiting for it to go up, but by strategically using options contracts to profit from the asset’s price movements.
Establishing a synthetic long requires purchasing at-the-money call options and selling put options at the same strike price and expiration. A synthetic long strategy has a bullish outlook since the maximum profit is unlimited while the downside risk, increases until the asset price goes to zero.
An investor puts on a synthetic long options position when bullish on the underlying asset, but wants a lower cost alternative to owning the asset. You can learn more about how options trading works with SoFi.
A synthetic long options position has the same risk and reward profile as a long equity position. The setup can be beneficial to traders since a lower amount of capital is needed to establish the position. The options exposure offers leverage while owning the asset outright does not.
A key difference between a synthetic long and a long position in the underlying asset is the time limit dictated by the option’s expiration date. The options trader also does not have shareholder voting rights and will not receive dividends.
How Do Synthetic Longs Work?
Synthetic longs work by offering the options trader unlimited upside via the long call position. If a trader was very bullish, they might buy only the long call.
However, the short put helps finance the synthetic long trade by offsetting the expense of buying the long call. In some cases, the trade can even be executed at a debit (profit) depending on the premiums of the two options.
By including the short put, the investor can be exposed to losses, should the asset price drop below the strike price of the short put, but no more than would be expected if the trader went long the underlying asset.
Setup
A synthetic long options play is one of many popular options strategies, and it can be constructed simply: You buy close-to-the money (preferably at-the-money) calls and sell puts at the same strike price and expiration date.
Your expectation is to see the underlying asset price rise just as you would hope if you were long the asset outright. If you’d rather own the asset outright, you can always purchase the stock directly through your brokerage.
Maximum Profit
There is unlimited profit potential with a synthetic long, just as there is with a long position. If the underlying share price rises the value of the call will increase and you can sell the call at a profit while covering (buying back) the short put to close out your trade.
Breakeven Point
A synthetic long’s breakeven point is calculated as the strike price plus the debit (cost) paid or minus the credit (profit) received at the onset of the trade.
Maximum Loss
The maximum loss is limited, but only because an asset’s price can’t drop below zero, but it can be substantial. Losses are seen if the underlying share price drops below the break even point and maximized if the asset price drops to zero.
In the event that the asset price drops below the strike price of the short put, the trader can be assigned shares and would be obligated to buy the asset at the strike price. The risk of assignment increases as the asset price drops and the option nears expiration, but it can happen at any time once the asset trades below the strike price.
The loss would be slightly higher or lower based on the credit or debit of the initial trade.
Exit Strategy
Most traders do not hold a synthetic long through expiry. Rather, they use options to employ leverage with a directional bet on the underlying asset price, then exit the trade before expiration.
To exit the trade, the investor sells the long call and buys back the short put. This tactic avoids buying the underlying asset and the increased capital outlay that would incur.
Recommended: Margin vs. Options: Similarities and Differences
Synthetic Long Example
Let’s say you are bullish shares of XYZ company currently trading at $100. You want to use leverage via options rather than simply buying the stock.
You construct a synthetic long options trade by purchasing a $100 call option contract expiring in one month for $5 and simultaneously selling a $100 put option contract at the same expiration date for $4. The net debit (premium paid) is $1.
Net debit = Call Option Price – Put Option Price = $5 – $4 = $1 per share
Note: The $1 net debit is per share. Since an option contract is for 100 shares, the debit will be $100 per option contract.
If the asset price falls, you experience losses. If the stock price drops to $90 after one week, the put premium rises to $12 while the call option price falls to $4. Your unrealized loss is $9 (the long call price minus the short put price minus the net debit paid at initiation).
You choose to hold the position with the hope that the stock price climbs back. Because the stock price has dropped below the $100 strike price you are at risk of your short put being exercised and assigned.
Unrealized loss = Long Call Price – Short Put Price – Net Debit at Initiation
Unrealized loss = $4 – $12 – $1 = Loss of $9 per share or $900 per option contract
A week before expiration, the stock price has risen sharply to $110. You manage the trade by selling the calls and covering the short put. At this time, the call is worth $12 while the put is worth $3. The net proceeds from the exit is $9. Your profit is $8 ($9 of premium from the exit minus the $1 net debit).
Profit = Long Call Price – Short Put Price – Net Debit at Initiation
Profit = $12 – $3 – $1 = Profit of $8 per share or $800 per option contract
You could hold the trade through expiration but would then be exposed to having to own the stock.
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Calculating Returns
A synthetic long replicates a long position in the underlying asset but at a lower cost.
In the example above, an investor might have purchased 100 shares of XYZ at $100 each for a capital outlay of $10,000. If the shares closed at $110, the long position would be worth $11,000.
$ Gain = Selling Price – Purchase Price
$ Gain = $11,000 – $10,000 = $1,000
% Gain = $ Gain / Purchase Price
% Gain = $1,000 / $10,000 = 10% Gain
The synthetic long in the example above is substantially cheaper at a cost (debit) of $100 for one option representing 100 shares of XYZ. When sold, the options were worth $900.
$ Gain = Selling Price – Purchase Price
$ Gain = $900 – $100 = $800
Note this gain is approximately the same as the gain if the shares were bought.
% Gain = $ Gain / Purchase Price
% Gain = $800 / $100 = 800% Gain!
As you can see, while dollar gains are very similar, the percentage gains are larger due to the power of leverage using options. But leverage works both ways.
If we take a loss on a synthetic long, dollar losses will also be in line with losses on a long position, but percentage losses can be as outsized as the gains.
Pros and Cons of Synthetic Longs
| Pros | Cons |
|---|---|
| Unlimited upside potential | Substantial loss potential if the stock falls to zero |
| Uses a smaller capital outlay to have long exposure | You do not have voting rights or receive dividends as a shareholder would |
| You can define your reward and risk objectives | The trade’s timeframe is confined to the options’ expiration date |
Alternatives to Synthetic Longs
To have long exposure to a stock you can simply own the stock outright. Stock ownership carries with it the benefits of voting rights and dividends but at a much higher capital outlay.
Another alternative similar to a synthetic long options trade is a risk reversal. A risk reversal options trade is like a synthetic long, but the strike price on the call option is higher than the put strike price. A risk reversal is also known as a collar.
A synthetic long call can also be created with a long stock position and a long put.
A bearish alternative is a synthetic long put strategy. A synthetic long put happens when you combine a short stock position with a long call.
The Takeaway
Options synthetic long strategies combine a short put and a long call at the same strike and expiration date. It replicates the exposure of being long the underlying asset outright — but the investor needs a lower-cost alternative to owning the asset. It’s one of many options strategies that allow traders to help define their risk and reward objectives while employing leverage.
Putting on a synthetic long position means buying at-the-money call options and selling put options at the same strike price and expiration. This strategy has a bullish outlook because the maximum profit is unlimited, while downside risk increases until the asset price goes to zero.
If you’re ready to try your hand at options trading, SoFi can help. You can set up an Active Invest account and trade options onlinefrom the SoFi mobile app or through the web platform. And if you have any questions, SoFi offers educational resources about options to learn more. SoFi doesn’t charge commission, and members have access to complimentary financial advice from a professional.
FAQ
What is a long combination in options trading?
A combination is a general options trading term for any trade that uses multiple option types, strikes, or expirations on the same underlying asset. A long combination is when you benefit when the underlying share price rises.
How do you set up a synthetic long?
A synthetic long is established by buying an at the money call and selling a put at the same strike price. The options have the same expiration date. The resulting exposure mimics that of a long stock position.
What is the maximum payoff on a synthetic long put?
The maximum payoff on a synthetic long put happens if the stock price goes to zero. Maximum profit when the underlying stock goes to zero is the strike price of the put minus the premium paid to construct the trade.
Photo credit: iStock/FG Trade
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