The Joys of Polyester — A How-To on Synthetic Positions
Unlike my other posts, this one will actually be trading related.
If you’re reading this and can’t find my previous posts, they’re currently on reddit.com/r/thecorporation, but I will migrate them here soon!
One of my most common tools, especially with a large portfolio and hence lots of collateral (easy enough to do in a 401k or similar investment vehicle) is synthetic positions — positions that recreate the payoff of other positions using in this case options.
In particular, one of the safest option strategies, especially if you’re bullish on the underlying but less sure about short term movements is to buy what’s called a LEAP (Long-term Equity Anticipation) option, which is usually a call at least 6 months away in expiry (it can also be a put, but this is less common).
What’s interesting about synthetic positions again is our friend delta — remember an at-the-money position by definition has 50 delta, right? If we go back to our definition of delta from posts past, what this means is — “what we expect our position to move in cents given the underlying moves up/down $1”. So if I have a 50 delta LEAP, effectively I have the same exposure to the underlying stock as buying 50 shares — at much much lower cost.
However, in good stocks, LEAPs are still quite expensive, especially to get a nice 50 delta call. Additionally, you end up at the mercy of IV — if you buy on the wrong day when the LEAP is expensive, you can get crushed. Or the underlying can move against you too. Still lots of ways to go wrong.
The ‘basic’ synthetic long is constructed like this:
- Buy 1 ATM LEAP call (so for example, this could be $215C 5/2021 on MSFT) [+50 delta]
- Sell 1 ATM LEAP put (so for example, this could be $215P 5/2021 on MSFT) [-50 delta, but you sold it, so your exposure becomes +50 delta]
What this effectively means is you get 100 delta exposure — the same as 100 shares roughly — on $MSFT for…. $175 credit! So instead of paying up front $215 x 100 for shares ($21,500) you get the exact same exposure (for moderate moves) by setting up the synthetic long as you do by actually buying the shares and putting the money up front.
BUT….
The catch here is you’re selling a put, which requires collateral. Your broker isn’t stupid — they need to. make sure if MSFT goes to $190, that you can actually pay out on the put. This collateral comes in many forms:
- Stocks (if you own enough stocks, you can use them as collateral via portfolio margin)
- Cash (this would ATM roughly mean holding $21,500 in broker escrow, which… isn’t an improvement over just buying the stock).
My Preferred Method
For the issue above, I don’t use traditional synthetic longs, because they’re not that useful vs buying the stock. In particular, your risk ends up identical given you sold the put, right?
But there’s no rule that you *have* to buy the ATM call, and sell the ATM put. In general, my version goes like this:
- Buy 20–30 delta call LEAP (for MSFT this could be like $235C 4/2021)
- Sell 20–30 delta put LEAP (for MSFT this could be like $190P 4/2021)
- Buy 3–5 delta put LEAP (for MSFT this could be like $170P 4/2021)
The reason for this is multi-fold:
- You have much more flexibility selling the put OTM, which means that even if the position moves against you for a while, you don’t need to worry too much. As long as you think it doesn’t hit your outermost put strike by the LEAP date, you’re good!
- I buy the 3–5 delta put LEAP as coverage. I expect it to expire worthless, but this does three things:
- It protects you MASSIVELY in tail risk events — you end up losing a capped amount rather than however low the stock goes.
- It’s very cheap (I usually aim for <$1, sometimes less)
- It lowers the margin you need to use. In general, the options price is dictated by delta, but 0 delta does not equal $0 on a stock. Often selling a put credit spread with the long leg basically 0 delta (3–5 delta) is almost identical in premium to a single short put, but your risk is much less in catastrophic events.
Hope this helps!
In general, this method nets me a 50–60 delta position for a fraction of the ATM cost (in exchange for more risk, of course). Sometimes it ends up even free. It’s awesome.
Some recent examples from me:
- BTO (Buy to open) AMWL 35C 3/2021, STO (Sell to open) 25P 3/2021, BTO 15P 3/2021
- BTO TDOC 220C 4/2021, STO 160P 4/2021, BTO 95P 4/2021
