Investing in T-bills (Part 6)

Today, I continue addressing the first consideration when comparing stock investing (S&P 500 ETFs and mutual funds, in particular) with synthetic long stock / T-bills.

As mentioned in the second-to-last paragraph of Part 5, synthetic long stock requires advanced trading permissions from the broker [score one point for stock investing]. I think this is mainly due to a need for close monitoring as expiration approaches and knowledge required about proper management depending on whether the underlying has gone up or down.

If the underlying (ETF) has increased through expiration,* the long call must be sold [thereby incurring slippage, commission, and exchange fees—score another point for stock investing] because automatic exercise will occur if in-the-money (ITM) by at least $0.01. This cannot be allowed to happen because avoiding stock purchase is precisely why the synthetic is being traded in the first place. The short put can probably be left to expire with close monitoring for sudden downside movement if the ETF is trading anywhere near the stock price** in order to prevent what I will describe next.

If the underlying has decreased through expiration,* the short put must be bought (to close) [again incurring slippage, commission, and exchange fees]. The short put may be assigned early if it goes deep ITM or assigned at/near expiration if it is even slightly ITM. Extrinsic value is something to be monitored; if this shrinks to a penny or two,*** then immediate closing (rolling) is prudent. Any extrinsic value in the long call could be salvaged by a sale. In fact, for the synthetic long stock to perfectly mimic gain/loss of the underlying shares, both options should be closed together and concomitantly replaced with a later-dated position.****

I have at least two ideas to significantly limit assignment risk. First, avoid expiration week altogether by rolling synthetic long stock no later than 7 DTE. Especially if positions are established far from expiration, the difference between rolling at 7 DTE vs. expiration week proper is trifling. Second, trade the synthetic with SPX options rather than SPY. Any assignment of SPX options results in a cash credit/debit for the difference between strike price and underlying [SPX index] price rather than an obligation to buy the full 100 shares of SPY [multiplied by number of contracts].

I will continue next time with a brief discussion of option liquidity for S&P 500 ETFs.


* — Assuming an at-the-money synthetic stock position at inception, which need not be the case.
** — This applies more to PM-settled options that can be monitored right up to expiration. Closing
         AM-settled by 4:15 PM ET (check option specifications for exact trading hours) is prudent
         when trading within a couple (few?) standard deviations of the strike price to limit chances
         of a big overnight move resulting in assignment.
*** — $0.05 – $0.10 for SPX options
**** — “Concomitantly” makes this a theoretical impossibility but opening a new synthetic long
             stock position ASAP after closing the existing is sufficient.