Friday, December 9, 2022 By Jerry Nix | FreeWaveMaker, LLC
Merry Christmas to all readers:
Since this will probably be my final article for this disastrous 2022 year in the stock market, I thought I’d send this one out as a Christmas Gift from me to you. Please enjoy it and see if you can learn something new going into 2023 – which I anticipate to be a better year, if the politicians and media talking heads would do their jobs and quite forecasting doom and gloom.
What is a synthetic stock?
I will explain that with an example.
Let’s assume you are a small investor (with $5,000 or less to invest) and you want to purchase shares of a rather large company that has a stock price well into the hundreds of dollars. A good example may be Microsoft (MSFT) which, as of this writing, was selling for $247.89 per share. So, to purchase 100 shares of the stock would cost you as follows:
$247.53 X 100 shares = $24,753.00
The problem is … You are a small investor and don’t have that much money in your account. However, you have witnessed the price of MSFT to grow as follows over the past five years.
And, even though it has had a pull back in 2022 (as have many stocks) you see it is off its lows of a few weeks ago and you think that it will only go higher over the next few years. But it still remains, you don’t have enough money in your account to purchase 100 shares at $24,753 or even 50 shares at a cost of $12,376.50 or even 25 shares at a cost of $6,188.25. All you have is, let’s say, $5,000.
Now you could purchase 20 shares for a total of $4,950 …
~~ OR ~~
You could elect to create a synthetic stock:
When you do this, you are not actually purchasing the stock but rather a Call Option on the Stock. This option should be At the Money (ATM) or as close to ATM as possible. At the time you purchase the Call Option on the stock you should also sell a Put Option with the same strike price and expiration date.
If we look at a monthly options chain on MSFT today (as far as potential expirations go) this is what we see options expiring in …
- December 2022
- January 2023
- February 2023
- March 2023
- April 2023
- June 2023
- July 2023
- September 2023
- January 2024
- June 2024
- January 2025
In addition, MSFT does have weekly options expirations but we will not be discussing these in this article.
Now the longer you go out in time, the more expensive the options will become.
- A $250 strike January 2023 Call Option would have a premium of about $9.05 per share whereas the same Put Option would have a premium of about $11.05 per share (as I write this)
- A $250 strike January 2025 Call Option would have a premium of about $49.83 per share and the same Put Option would have a premium of $36.28 per share as I write this.
Knowing that MSFT started the year at $335.35, and you believe it can get back to the in the next one to two years, you may want to consider one of the following options combinations:
Right away you can see that paying $31.03 to $40.85 per share is a whole lot less than paying $247.89 per share … but it even gets better.
On the Call Options you purchase you do pay a premium … but on the Put Options you sell you get paid the premium.
So, what would each of these options combinations cost you on a net basis (not including commissions of course)?
- January 17, 2025: $49.90 – $35.93 = $13.97 per share; $1,397 per contract.
- June 21, 2024: $41.95 – $32.35 = $9.60 per share; $960 per contract.
- January 19, 2024: $35.85 – $28.40 = $7.45 per share; $740 per contract.
Note: Each contract equals 100 shares.
The question is: would you prefer to invest $24,753 to control 100 shares of MSFT or would it make more sense to invest between $740 and $1,397 to control 100 shares of the same stock? I think you know the answer – especially considering your small account size of just $5,000.
Now you know or have read that you should never put “all your eggs in one basket.” If you did one contract of the first option combination of the above you would have $3,603 to invest elsewhere. If you did one contract of the second option combination you would have $4,040 to invest elsewhere. And if you did one contract of the third option combination you would have $4,260 to invest elsewhere – perhaps in other such synthetic stocks you create.
Let’s assume that you chose the third combination from above:
You paid $3,585 to purchase the $250 January 19, 2024 Call Option and was paid $2,840 to sell the $250 January 19, 2024 Put Option. Your net cost was $745. Then, you set back and let it work for you.
You wake up the morning of January 19 2024 and MSFT has grown from the current price of $247.53 per share to let’s say $300 per share. This means MSFT has gained $52.47 per share or 21.19%. Not bad for a year in a stock.
However, what’s the value of your options?
Your Put Option, since the stock went up in value, would be worthless. But remember, you were paid $2,840 to sell this option so not all was lost. Your Call Option on the other hand, while it would have no “time value” left (you’re out of time on expiration date) would have an “Intrinsic Value.”
What is the intrinsic value of an option? Pretty simple: it’s the stock price less the option strike price.
So, the intrinsic value of your Call Option would be $300 stock price – $250 Option Strike Price = $50.00 per share. One contract is 100 shares so your options value is a whopping $5,000.
How much did you pay for the options contracts counting both the Put and the Call Options? Answer = $745.
What was your gain here?
$5,000 – $745 = $4,255 or 571.14%
What is better?
A 21.19% gain on an investment of $24,753 (which you did not have to begin with) or a return of 571.14% on an investment of $745 (that also left more money in your account for other investments).
And the really good part is this:
The most you could lose had you invested all your money in the stock ($5,000) would be the $4,950 that you paid for 20 shares of the stock. The most you could lose on the “Synthetic Stock” that you created would be the investment of $745 that you paid for the options combination – if the stock went down rather than up.
As a matter of fact, if you invested $4,950 in 20 shares of the stock and it dropped just 15.15% in value – from $247.53 to $210.02 (and we’ve seen it can lose that much just based on 2022 returns) you would lose the $745 in the stock (the most you could lose in the synthetic stock made of options) and still have more to lose.
So, you are probably asking …
Why doesn’t everyone do “Synthetic Stock” rather than actual stock investing? That can be a real head scratcher of a question.
Much of the so-called “Smart Money” does invest this way. Others and institutions invest in stock because (a) some institutions (such as pensions) are required to or (b) in the case of some retail investors and some institutions … they are looking for dividends to supplement the growth of their portfolios or their income. With options, even in dividend paying stock, the options buyers and sellers do not get dividends or the right to vote the shares of the stock they control at the annual stockholders meetings.
I cannot give stock or investment advice so I will suggest this. If you are wanting to do this and don’t have a licensed financial advisor that you are paying for advice, do a few paper trades, shorter term, to see how it works out for you and to get used to placing the trades. If you do use a financial advisor, check with him or her to see what their thoughts are, and since you are paying for it, follow their advice.
At the present time I do not hold any stocks or options in MSFT and don’t plan on buying or selling any for the next few hours.