The synthetic playing field

Expectations play an important role in stock markets. An investor may buy stock expecting its price to appreciate, while another may short-sell in anticipation of a fall in price. If the markets do not move as anticipated, both can result in losses. Short- and medium-term investors bet on the direction that the stock market will take over a pre-determined span of time. However, they are often agitated by temporary dips and upswings in stock markets and this leads them to exit their positions. However, if one combines buying and short-selling with option instruments, it not only helps limit the losses but also prevents distractions caused by daily variations. The combination of stocks and options proves beneficial when investors want to bet on the market direction over one to three months. This hedges their positions and provides opportunities for unlimited gains with limited risk. Let us understand these strategies

 

Hedging long position: The risk in a long position is due to the likelihood of a crash in the stock price. It can be hedged by buying a put option, which should have the same stock as the underlying security held by the investor. The strike price of the option should be equal to, or slightly lower than, the purchase price of the stock.

If the stock price rises, the investor benefits from price appreciation (after subtracting the cost of put option, plus brokerages and commissions). However, if the price falls, the investor can exercise the put option and, thereby, limit the loss. This combination of a stock and a put option is called synthetic long call because the pay-off from this strategy resembles the pay-off in the long call strategy (see Take a Call, October 2009). However, there are considerable differences between the two calls. In case of a long call, the investor does not need to hold the stock, whereas synthetic long call insures against the downside risk of a stock that is already owned. Also, in a synthetic long call, the investor has taken an exposure to the stock to reap the benefits of price rise, dividends, bonus, rights, etc.

 

Hedging short position: The risk from short positions originates due to the probability of a rise in the stock price. It can be hedged by buying a call option, which should have the same stock as the underlying security that the investor is short-selling. The strike price of the call option should be equal to the sale price of the stock or slightly higher. The investor will benefit if the stock price falls (after subtracting the cost of option, plus brokerages and commissions). On the other hand, if the price rises, the investor can exercise the call option to limit the loss. This combination is termed as synthetic long put.

In case of adverse circumstances, the pay-off from the options will increase in both the cases, which will help in restricting the loss. Let's consider an example.

XYZ Corporation
CMP (Rs)	150
Synthetic long call: BUY STOCK, BUY PUT
TRADER'S NAME	YOGESH
No. of shares purchased	200
Cost of purchase (Rs)	30,000
Put option
UNDERLYING SECURITY	XYZ CORPORATION
Strike price (Rs)	150
Premium (Rs)	20
Market lot (shares)	100
Cost of trade (Rs)	4,000
Synthetic long call: SHORT-SELL STOCK, BUY CALL
TRADER'S NAME	RAJEEV
No. of shares short-sold	200
Sale proceeds (Rs)	30,000
Call option
UNDERLYING SECURITY	XYZ CORPORATION
Strike price (Rs)	150
Premium (Rs)	18
Market lot (shares)	100
Cost of trade (Rs)	3,600
Assuming zero brokerages & commissions

 

The shares of XYZ Corporation are trading at Rs 150. Two investors, Yogesh and Rajeev, have different expectations regarding the share price movement over the next month. Yogesh believes the price will rise, whereas Rajeev expects it to crash. Both want to insure their positions against unfavourable outcomes. A put option with a strike price of Rs 150 is available for Rs 20, whereas a call option is available for Rs 18. The market lot is 100 shares. Yogesh enters the synthetic long call by buying 200 shares of XYZ Corp at Rs 150 per share and two ATM (at the money) put options for Rs 4,000 (20 x 100 x 2). On the other hand, Rajeev shortsells 200 shares and buys two ATM call options for Rs 3,600 (18 x 100 x 2) and enters the synthetic long put. We assume zero brokerages and commissions.

The pay-off from the synthetic long call offers the benefits of price rise. However, these accrue once the stock price recovers the cost of put option, that is, it moves beyond the break-even level of Rs 170 (the purchase price of the stock and the put option premium). On the other hand, if the expectation proves to be wrong, the loss is limited to Rs 4,000.

The pay-off from the synthetic long put is the reverse. Here, benefits will be available if the stock price crashes, but the profits will accrue once the price falls below the break-even level of Rs 132 (subtracting the call option premium from the price at which the stock is short-sold). However, if the price rises, the loss will be limited to Rs 3,600.