Options are touted as one of the most common ways to profit from market swings. Whether you are interested in trading futures, currencies or want to buy shares of a corporation, options offera low-cost way to make an investment with less capital.
While options have the ability to limit a trader's total investment, options also exposetraders to volatility, risk, and adverseopportunity cost. Given these limitations, a synthetic option may be the best choice when making exploratory trades or establishing trading positions.
Key Takeaways
- A synthetic option is a way to recreate the payoff and risk profile of a particular option using combinations of the underlying instrument and different options.
- A synthetic call is created by a long position in the underlying combined with a long position in an at-the-money put option.
- A synthetic put is created by a short position in the underlying combined wit a long position in an at-the-money call option.
- Synthetic options are viable due to put-call parity in options pricing.
Options Overview
There is no question that options have the ability to limit investment risk. If an option costs $500,the maximum that can be lost is $500. A defining principle of an option is its ability to provide an unlimited opportunity for profitwith limited risk.
However, this safety net comes with a costbecause manystudies indicate the vast majority of optionsheld until expiration expireworthless. Faced with these sobering statistics, it is difficult for a trader to feel comfortable buying and holding an option for too long.
Options "Greeks" complicate this risk equation. The Greeks—delta, gamma, vega, theta, and rho—measure different levels of risk in an option. Each one of the Greeks adds a different level of complexity to the decision-making process. The Greeks are designed to assess the various levels of volatility, time decay and the underlying asset in relation to the option. The Greeks make choosing the right option a difficult task because there is the constant fear that you arepaying too muchor that the option will lose value before you have a chance to gain profits.
Finally, purchasing any type of option is a mixture of guesswork and forecasting. There is a talent in understandingwhat makes one option strike price better than anotherstrike price. Once astrike price is chosen, it is a definitive financial commitment and the trader must assume the underlying asset will reachthe strike priceandexceed it to book aprofit. If the wrong strike price is chosen, the entire strategy will most likely fail. This can be quite frustrating, particularly when a trader is right about the market's directionbut picks the wrong strike price.
Synthetic Options
Many problems can be minimized or eliminated when a traderusesa synthetic option instead of purchasing a vanillaoption. A synthetic option is less affected by the problem of options expiring worthless; in fact, adversestatistics can work in a synthetic's favor because volatility, decay and strike price play a less important role in itsultimate outcome.
There are two types of synthetic options: synthetic calls and synthetic puts. Both typesrequire a cash or futures position combined with an option. The cash or futures position is the primary position and the option is the protective position. Being long in the cash or futures position and purchasing a put option is known as a synthetic call. A short cash or futures position combined with the purchase of a call option is known as a synthetic put.
A synthetic call lets a trader put on a long futures contract at a special spread margin rate. It is important to note that most clearing firms consider synthetic positions less risky than outright futures positionsand therefore requirea lowermargin. In fact, there can be a margin discount of 50% or more, depending on volatility.
A synthetic call or put mimics the unlimited profit potential and limited loss of a regular put or call option without the restriction of having to pick a strike price. At the same time, synthetic positions are able to curb the unlimited risk that a cash or futures position has when traded without offsetting risk. Essentially, asynthetic optionhas the ability to give traders the best of both worldswhile diminishing some of the pain.
How a Synthetic Call Works
A synthetic call, also referred to as a synthetic long call, begins with an investor buying and holding shares. The investor also purchases anat-the-moneyput option on the same stock to protect against depreciation in the stock's price. Most investors think this strategy can be considered similar to an insurance policy against the stock dropping precipitously during the duration that they hold the shares. A synthetic call is also known as a married call or protective call.
How a Synthetic Put Works
A synthetic put is an options strategy that combines ashortstock position with along call optionon that same stock to mimic along put option. It is also called a synthetic long put. Essentially, an investor who has a short position in a stock purchases anat-the-moneycall option on that same stock. This action is taken to protect against appreciation in the stock's price.
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Disadvantages of Synthetic Options
While synthetic options have superior qualities compared to regular options, that doesn't mean that they don't generatetheir own set of problems.
If the market begins to move against a cash or futures position it is losing money in real time. With the protective option in place, the hope is that the option will move up in value at the same speed to cover the losses. This is best accomplished with an at-the-money optionbut theyare more expensive than an out-of-the-money option. In turn, this can have an adverse effect on the amount of capital committed to a trade.
Even with an at-the-money option protecting against losses, the trader must have a money management strategy to determine when to get out of the cash or futures position. Without a plan to limit losses, traders can miss an opportunity to switch a losing synthetic position to a profitable one.
Also, if the market has little to no activity, the at-the-money option can begin to lose value due to time decay.
Example of a Synthetic Call
Assume the price of corn is at $5.60 and market sentiment has a long side bias. You have two choices: you can purchase the futures position and put up $1,350 in margin or buy a call for $3,000. While the outright futures contract requires less than the call option, you'll have unlimited exposure to risk. The call option can limit riskbut is $3,000 is a fair price to pay for an at-the-money option and, if the market starts to move down, how much of the premium will be lostand how quickly will it be lost?
Let's assume a $1,000 margin discount in this example. This special margin rate allows traders to put on a long futures contract for only $300. A protective put can then be purchased for only $2,000 and thecost of the synthetic call position becomes $2,300. Compare this to the $3,000for a call option alone, bookingis an immediate $700 savings.
Put-Call Parity
The reason that synthetic options are possible is due to the concept of put-call parity implicit in options pricing models. Put-call parity is aprinciple that defines the relationship between the price of put options and call options of the same class, that is, with the same underlying asset, strike price, and expiration date.
Put-call parity states that simultaneously holding a short put and long European call of the same class will deliver the same return as holding oneforward contracton the same underlying asset, with the same expiration, and aforward priceequal to the option's strike price. If the prices of the put and call options diverge so that this relationship does not hold, anarbitrageopportunity exists, meaning that sophisticated traders can theoretically earn a risk-free profit. Such opportunities are uncommon and short-lived in liquid markets.
The equation expressing put-call parity is:
C+PV(x)=P+Swhere:C=priceoftheEuropeancalloptionPV(x)=thepresentvalueofthestrikeprice(x),discountedfromthevalueontheexpirationdateattherisk-freerateP=priceoftheEuropeanputS=spotpriceorthecurrentmarketvalueoftheun-derlyingasset
The Bottom Line
It's refreshing to participate in options trading without having to sift through a lot of information in order to make a decision. When done right, synthetic options have the ability to do just that: simplifydecisions, make trading less expensive and help tomanage positions more effectively.
