Synthetic Long
Outlook: Bullish

The "synthetic long" derives its name from the fact that it mimics the risk/reward profile of a straightforward stock purchase. By combining a short put and a long call at the same strike, the spread profits when the underlying security moves higher, but racks up losses quickly on a pullback. (By comparison, limited downside risk is one of the main attractions of a traditional call-buying strategy.) As a result, the synthetic long is best reserved for those traders who are very confident in their bullish forecast for the shares.

To understand how the synthetic long works, let's break down an example.

Entering the Trade

With Stock XYZ trading at $40 per share, you're targeting a near-term rally up to at least the $45 level. To play this bullish forecast, you initiate a synthetic long by buying to open a 40-strike call for the ask price of 0.85, and simultaneously selling to open a 40-strike put for the bid price of 0.84. Subtracting your credit of 0.84 from your debit of 0.85, it cost you just 0.01 to enter the trade -- or $1, after accounting for 100 shares per contract.

Potential Gains

Due to your low cost of entry, you'll begin to see profits almost immediately on a rally. Breakeven is equal to the purchased call strike plus net debit, which in this case is 40 + 0.01. So, as soon as XYZ surmounts $40.01 per share, your gains will begin to accrue. Since there's no limit to how high the stock can rally, potential profits are theoretically unlimited.

Assuming XYZ matches your expectations and closes at $45 per share upon expiration, the short put can be left to expire worthless. Meanwhile, your purchased call can be sold to close with an intrinsic value of 5.00. Subtracting your net debit of 0.01, you're left with a profit of 4.99 -- or $499, given 100 shares per contract.

Potential Losses

If XYZ ends squarely at $40 upon expiration, both options can be left to expire worthless, and the most you can lose is your initial net debit of 0.01, or $1.

On the downside, you'll suffer additional losses as the stock falls below the put strike. And those losses are potentially steep; if the stock tumbles to zero, your maximum downside risk is equal to the put strike plus net debit. In other words, if the bottom falls out, you could lose up to 40.01. Multiplied by 100 shares per contract, that's a possible risk of $4,001.

What's more, you could be assigned on the short put if it moves into the money. Due to the substantial downside risk involved, there is a margin requirement associated with a synthetic long -- which will generally be equivalent to your broker's requirement for any put-sell position.

Volatility Impact

The effects of implied volatility are somewhat muted in a synthetic long, since you're simultaneously long and short two options at the same strike. However, if the call moves into the money, you'd then prefer to see implied volatility rise, thereby upping the value of your long option. Conversely, if XYZ sinks below the put strike, a volatility decline would work in your favor.

Other Considerations

As you can clearly see in the example above, the reduced cost of entry is a major benefit to playing a synthetic long. In fact, this trade can also be initiated for a net credit -- in which case your breakeven level would be equivalent to the call strike less net credit. Your maximum loss, meanwhile, would be the put strike minus net credit. Of course, the significantly steeper potential loss is the risk you take on in exchange for the lower cost of entry, so be sure you weigh these factors carefully before trading a synthetic long.

While the traditional version of this spread dictates that the call and put coexist at the same strike, you can mix up your approach with a "split strike" variation. By spreading out your strikes, you can create a little more breathing room for the stock before losses begin to add up.