Options Update: Simulating a Long Stock Position on Deere & Company


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Farming equipment issue Deere & Company ( DE ) has been a favorite in the options pits today, with one speculator using calls and puts to simulate a long stock position on the equity.

Earlier today, the investor bought 2,000 December 80 calls for the ask price of $1.55 per contract, and simultaneously sold an equal amount of December 62.50 puts for the bid price of $1.43 per contract. In other words, the trader constructed a split-strike version of the synthetic long stock strategy for an initial debit of $0.12 per pair of options.

By buying out-of-the-money calls and selling out-of-the-money puts, the strategist is hoping to simulate the payoff of a long stock position - but at a fraction of the cost. In this particular situation, the trader - like a stockholder - is betting the shares of DE will rally in the intermediate term, as his profit will increase with each step the stock takes north of the $80.12 level (call strike plus net debit).

However, the options player stands to forfeit a lot less cash in the wake of a slight pullback on the charts. More specifically, even if the shares of DE tumble to the $63 level before December-dated options expire, the speculator's risk is limited to the $0.12 paid to establish the play. Beyond the $62.50 level, though, the investor's losses will accrue in parity with DE's decline, as the sold 62.50-strike puts would move into the money.

Synthetic long stock position on DE

To emphasize the leverage provided by options, let's compare the risk/reward profile of the aforementioned strategy to that of buying the shares of DE outright. Since each option represents 100 shares of the equity, we know the options trader spent $12 ($0.12 x 100 shares) to establish the synthetic position. On the other hand, a straightlaced stock trader would've spent roughly $7,300 to own 100 shares of DE, assuming he bought the stock just before Tuesday's closing bell.

Synthetic long stock on DE Now, let's fast-forward a couple of months...

First, let's assume the shares of DE plummet to the $60 level. In this instance, the long 80-strike call would expire worthless, while it would cost the options trader $250 (intrinsic value of $2.50 x 100 shares) to buy back the 62.50-strike put. Adding the initial net debit of $12, the options player's loss would amount to $262 per pair of contracts. On the other hand, the stock trader's 100 shares of DE would be worth just $6,000 - a loss of $1,300 from his initial investment.

Moving on, let's say the shares of DE retreat to the $70 level before December-dated options expire. In this scenario, both options will expire worthless - meaning the strategist will be out the $12 paid to establish the trade. Meanwhile, the stockholder's stake would be worth just $7,000 - a $300 deficit.

Now, what happens if the shares of DE rally to the $85 level by expiration? In this best-case scenario, the sold put would expire worthless, while the bought 80-strike call would have an intrinsic value of $5, or $500 (x 100 shares). Subtracting the initial debit of $12, the options trader would net a profit of $488 - a return of more than 4,000%. In comparison, the stock owner's shares would be worth a combined $8,000 - a profit of $700, or less than 10% of his initial investment.

In conclusion, by employing the right options strategy, bullish bettors can simulate the payoff of stock ownership without having to fork over a ton of cash. Plus, since the aforementioned strategist sold puts and bought calls at different strikes, his risk is limited should the equity remain between the strikes through expiration. In fact, some synthetic long stock positions are even initiated for a net credit - meaning the investor can net a small profit even amid stagnant price action.

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This article appears in: Investing , Options

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