How to Buy Stocks Without Spending Cash

Education goes a long way in business and investors with knowledge will always have the upper hand. That is why more and more traders have abandoned the "buy and hold" strategy and are replacing it with a less commonly discussed strategy known as a synthetic long.

The strategy mimics a long equity position through the use of options. Two bullish trades are executed that require significantly less capital yet carries the same risks and reward.

The first part of the strategy requires the purchase of a call option, known as the long call. If the trader is correct, the long call will rise as the stock rises. The second part requires the sale of a put option, known as the short put. If the trader is correct, the short put will decrease in value as the stock rises. Shorting (or writing) a put option may require upgrades to your margin account so verify with your brokerage.

Since we are replicating a long-term purchase, it is prudent to use LEAPS (Long-term Equity Anticipation Security). LEAPS are long-term options and typically expire in January of a future year. In fact, LEAPS are already available for expiration on January 17, 2015.

Shares of Apple [AAPL:NSD] closed October 2, 2012 at $661.31. The purchase of a board lot (100 shares) would require an initial investment of $66,131, but not all investors have the capital nor the income to pay interest on borrowed money for such a purchase. As a result, Apple is a good candidate for the synthetic long.

Long Equity

An investor looking to buy the shares would require the $66,131 up-front or could borrow on margin with a minimum deposit of $19,840 (30% margin requirement) but would pay interest on $46,291. Total margin required is a minimum of $19,840.

Synthetic Long

Another investor looking to create a synthetic long would require a deposit equal to the margin required to purchase the call option and the margin required to sell a put option. Using a strike price of 660 for both options, we find the call option is asking $102.50 and the put option is bidding $106.60. Now that we have this information, let us examine the steps and margin requirements.

Step One: Long Call

The Jan 2015 660 call option would be purchased for $10,250 to mimic 100 shares of Apple. A hefty price, but a fraction of the stock holder's initial payment. Total margin required is $10,250.

Step Two: Short Put

The Jan 2015 660 put option would be sold for $10,660 to mimic 100 shares of Apple. The estimated margin required is $13,095 (to view the formula, click here under short uncovered puts or click here for the online calculator).

The margin required for a synthetic long is $23,755 and is equal to the minimum initial deposit. Another thing to note is that the synthetic long automatically generates $410. This investor would actually have $24,165 in the account while the long-term stock holder has paid at least $66,131 for Apple.

The reason that the option trader earns money today is because they forfeit their right to receive future dividends. The call option would discount the value of the dividends in its price calculating the value of time and interest, which is why the put option costs more than the call, even though the call is in-the-money. If you didn't get that, don't worry about it!

Two things can happen to a stock in 15 months. It can rise or it can fall.

If Apple rises, the long-term holder profits the difference in share price at sale and dividends received. The option trader would see the call option rise and be able to sell it; the put option would decrease in value and eventually be worthless. The option trader's profit is the gain (if any) in the value of the call option plus the entire value of the original sale of the put option.

For example, if Apple rises to $800 on January 16, 2015, the stock holder profits $13,869 and earns $331.25 in five dividends. This totals $14,200.25. Meanwhile, the option trader earns $3,750 on the call option plus $10,660 on the put option. This totals $14,410. As we see, the option trader will generate more income after dividends by $210 assuming the stock holder has not borrowed any money.

But what if Apple drops to $550? The stock holder loses $11,131 on the stock but earns $331.25 in dividends. This totals ($10,799.75). Meanwhile, the option trader loses $10,250 on the call option purchase and closes the put option at $110. The put option loses only $340. This totals ($10,590). As we see, the option trader loses less money in the same situation.

In the above example with Apple rising, both traders essentially earned the same amount of money, however, the option trader yielded nearly three times as much. The stock holder earned a handsome 21 per cent in 15 months, but the option trader earned more than 60 per cent in the same time period.

For new investors, the simple idea of an option is overly complicated, but for sophisticated investors, the strategy above is not so. We see that it is more efficient and yields better results, which is why we're seeing a small shift in options trading versus long-term strategies.