The Synthetic – Alternative to Stock

There is an old adage which says “Sell in May and Go Away”. It is widely used in media nowadays. But nobody talks about its relevance. The phrase is thought to originate from an old English saying, “Sell in May and go away, and come on back on St. Leger’s Day.” This phrase refers to a custom of aristocrats, merchants and bankers who would leave the city of London and escape to the country during the hot summer months. St. Leger’s Day refers to the St. Leger’s Stakes, a thoroughbred horse race held in mid-September.

American traders who are likely to spend more time on vacation between Memorial Day and Labor Day mimic this trend and have adopted the phrase as an investing adage. Stock market patterns have supported the theory behind the strategy.

Talking about strategy, 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.

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 would you 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.

For example, to purchase 500 shares of Reliance at a price of 1400 would cost 7,00,000 in cash. To buy an at-the-money synthetic would cost a net Rs 25, which is 1,25,000. With such a considerable difference in the cash flow difference means that with the synthetic you get to keep your cash and use it to earn interest.

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. The interesting thing here is that one can realign the strategy very quickly by adjusting one of the leg of the strategy. Another advantage of synthetics is that you can use them with assets where there is no tradable underlying, such as indices.

Happy Trading!!!

Cheers.