At what point is the synthetic preferable to long stock?

Discussion in 'Options' started by steve3052, May 9, 2006.

  1. Assuming a stock doesn’t pay dividends and I am willing to buy today and intend to hold it fairly long term, am I normally better with the synthetic equivalent – long call, short put? (any tax/capital gains issues aside)

    Appears that the downside vs buying the stock outright is two commissions and two spreads, both of which are normally wider than the spread on the underlying. But if I am going to hold long enough that this is offset from the interest I earn from keeping the cash I would have spent on the stock, seems I’m better off from that point on. Is that correct?

    If so, should I chose the synthetic with the highest strike – that way I am selling an expensive put and have more cash to earn interest on. Seems like the risk here would be that the put would be assigned, so I need to make sure I’m selling at something over parity so I don’t get assigned the same day. If do get assigned, it just equates to a small discount (equal to time value of sold put) on the stock, which I was ready to buy outright from the beginning. Still make sense?

    So here’s where I really get confused. If I can go both long and short via synthetics for a credit, that looks like a free loan until expiration – only there are now four spreads to deal with. Does the slippage normally eat up any interest I could have earned on the credits?

    One thing I’ve learned during my foray thus far into trading is that anytime I see something that looks like free money, at least for a retail trader, it pretty much always means I’ve either misunderstood something or overlooked a significant risk. Usually both!
  2. Maverick74


    No, no, no, no, lol. Not quite. The price of the synthetic stock is equal to the carry on the long stock plus the edge the mm wants for doing the spread. In other words, you are paying the interest from now till expiration through the synthetic. No free lunch.

    You don't need to worry about assignment unless you are overleveraged. Your position will remain exactly the same (long stock) and no you are not getting that stock at a discount.

    The reason for doing the synthetic over real stock is better margin. You are essentially getting 5 to 1 overnight margin vs 2 to 1. So if you want to leverage your position up, use synthetic stock. Otherwise there is no edge either way.

    All options have an interest rate component to them. That is why there is a greek (rho) that measures that risk. It doesn't matter which strike you choose but it would make sense to use the ATM's if only for the reason that they are the most liquid and will have the tightest spreads, especially if you are going far out in time.
  3. Gotcha.

    Appreciate the speedy reply!
  4. Ok, thought about it a bit more but I still think I’m missing something. Still seems that the carry rates can be less than my risk free return - money market or CD or the like.

    For example, here’s a (supposedly) real time quote on June GOOG options earlier today:

    stock ask -405.08
    put bid -75.4
    call ask 2.1
    strike 480

    Let’s say I buy the stock and sit on it through Monday after exp, 6/20. 41 days in the trade. If the stock goes nowhere, this has cost me what I would have earned in my MMF, which is about 4.5%: 405.08*0.045*41/365 = $2.05.

    If I buy the synthetic I take in a credit of the put bid less the call ask = 75.4-2.1 = $73.3. If the stock goes nowhere the call is worthless and I buy the put back at parity = 480-405.08 =$74.92.

    In addition, I have the use of the 73.3 credit for 41 days = 73.3*.045*41/365 = 0.37.

    So this exercise has cost me 74.92-73.3-.37 = $1.25.

    Seems like I’m effectively borrowing the funds for the stock at a rate of (1.25/405.08)*365/41 = 2.75%

    Are the quotes stale? Doesn’t make intuitive sense that the carry would be less than what I can buy a CD for.

    Also, where can I look up the actual carry. Is it listed somewhere, or does it vary depending on the MM?
  5. Maverick74


    Let me save you some time. The second you put that trade on you will get exciercised on the put which means you will own the actual stock and you will be paying interest on the stock from now till expiration at a debit rate of about 6%.

    You cannot sell DITM puts. Here is a general rule. The DITM put trades at parity with the DOTM call. If the carry is greater then the price of the call, the MM will excercise the ITM put. Therefore this whole trade never takes place. Once again, no free lunch.
  6. Your point's well taken - the bid on the seriously DITM calls is less than intrinsic value - makes sense that immediate assignment would result.

    But for the 480 strike, when I sell the put it has .48 of time value, if I'm computing correctly:

    strike-spot-put bid

    480-405.08-75.4 = .48

    If I get exercised immediately, haven't I just been given the .48?

    Have to sell my call back now, but the spread is much less than .48.
  7. Maverick74


    You are not factoring in the amount of interest you will pay to hold the stock from now till expiration. It will be a lot more then .48 I'll tell you that.
  8. Not following.

    Still not clear to me why immediate exercise of the put I sold doesn’t result in my buying the stock at a discount of .48. Why would I have to hold until expiration to realize this discount – isn’t it immediate?

    I do believe there’s no free lunch generally. I even think there’s no free lunch in this case – just bugs me that the numbers don’t work out when I look at it from the perspective of either buying the underlying or keeping my cash in MMF earning 4.5% and buying the synthetic instead.