Simulating the Underlying with Options
Did you know there is an option strategy – involving just two options – that behaves exactly like a position in the underlying? It's called a synthetic, because you're "synthesizing" a position in the underlying, and is like buying the stock itself.
A synthetic is constructed by buying a call and selling a put of the same strike and duration (to simulate being long the underlying), or buying a put and selling a call of the same strike and duration (to simulate being short the underlying).
Since a synthetic performs exactly the same as being long or short the underlying, the question naturally arises: Why do a position with two transactions when you can do it with one? Well, the fact is that the capital requirements for a synthetic can be a lot less than going long or short the stock, even when using maximum margin on the stock.
Let's look at a hypothetical example, XYZ Corporation that is currently trading at a price of $80.00 per share. Purchasing 100 shares of stock would cost $8,000 in cash (or $4,000 collateral on 50% margin). To buy an at-the-money synthetic would cost a net $20 cash, plus $2,380 collateral, for a total of $2,400. Not only is this a considerable difference in the amount of collateral required, the cash flow difference means that with the synthetic you get to keep your cash (all but $20 of it) in your account and earn interest on it.
The above illustration shows a Graphic Analysis of the synthetic long compared to the long stock position. The two lines are so close together they like a single line. However, the difference between the two trades becomes apparent when we switch the vertical from representing Profit/Loss to Yield, as in the illustration below.
Because of the lower capital requirement, the % gain (or loss) from the trade is much higher at every price of the underlying with the long synthetic position.
You're probably thinking there must be a catch. Is the synthetic riskier? Actually, since the synthetic delivers exactly the same performance as a position in the underlying itself, there is no additional risk in using a synthetic.
There are just two minor "catches". One is the fact that you miss out on any dividend income with the synthetic. The stock owner collects them, while the owner of a synthetic will not (the example used above assumes that the stock does not pay a dividend). The other is the possibility of early assignment if the short leg goes deep in-the-money. Early assignment is especially likely with a short deep-in-the-money put.
What would happen if you get assigned on that short put? You will now be long the stock (instead of short a put), plus still be long a call option. The long call option will be far out-of-the-money at that point, so it will be low priced and have very little delta. So you will essentially just be long stock, which is exactly the same in its performance as the original synthetic.
Thus you are not exposed to any sudden risk. There is no urgency to respond immediately in some way following assignment. While the cash flows of the assignment itself do not create a loss for you (or a gain), your collateral requirement will increase, since you now own the stock.
Another advantage of synthetics is that you can use them with assets where there is no tradable underlying, such as indexes. Let's say you are bullish on the semiconductor industry as a whole. Using the popular Philadelphia Semiconductor Index ($SOX), you can easily construct a long synthetic, in effect "buying" the index, a trade that could not be done without using options: