Understanding Synthetic Options

Options are considered one of the most common ways to profit from market fluctuations. Whether you are interested in trading futures or currencies, or want to buy shares in a company, options offer a cost-effective way to make an investment with less capital.

While options can limit a trader’s total investment, options also expose traders to volatility, risk, and adverse opportunity costs. Given these limitations, a synthetic option may be the best choice when making exploratory trades or establishing trading positions.

Options overview

There is no question that options can limit investment risk. If an option costs $500, the maximum loss is $500. A key principle of an option is its ability to provide unlimited profit potential with limited risk.

However, this safety net comes with a cost, as many studies indicate that the vast majority of options held until expiration expire worthless. Given these sobering statistics, it is difficult for a trader to buy and hold an option for too long.

Options “Greeks” complicate this risk equation. The Greeks – Delta, Gamma, Vega, Theta and Rho – measure different levels of risk of an option. Each of the Greeks adds a different level of complexity to the decision-making process. The Greeks are designed to evaluate the different 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 they are constantly worried that you will pay too much or that the option will lose value before you have a chance to win.

After all, buying any type of option is a mix of guesswork and predictions. There is a talent in understanding what makes the strike price of one option better than the strike price of another. Once a strike price is set, it is a final financial commitment and the trader must expect the underlying asset to meet and exceed the strike price to make a profit. If the strike price is chosen incorrectly, the entire strategy will most likely fail. This can be quite frustrating, especially when a trader is right about the market direction but chooses the wrong strike price.

Synthetic options

Many problems can be minimized or eliminated if a trader uses a synthetic option instead of purchasing a vanilla option. A synthetic option is less affected by the problem of options expiring worthless; In fact, negative statistics can work in a synthetic security’s favor because volatility, decay, and strike price play a less important role in the bottom line.

There are two types of synthetic options: synthetic calls and synthetic puts. Both types require 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. Going long on the cash or futures position and buying a put option is called a synthetic call. A short cash or futures position combined with the purchase of a call option is called a synthetic put.

A synthetic call allows a trader to enter into a long futures contract at a specific spread margin rate. It is important to note that most clearing firms consider synthetic positions to be less risky than outright futures positions and therefore require a lower margin. In fact, depending on volatility, there can be a margin discount of 50% or more.

A synthetic call or put mimics the unlimited profit potential and limited loss of a regular put or call option without the limitation of having to set a strike price. At the same time, synthetic positions can limit the unlimited risk that a cash or futures position brings to trading without offsetting the risk. Essentially, a synthetic option gives traders the best of both worlds while reducing hassle.

This is how a synthetic call works

A synthetic call, also called a synthetic long call, begins with an investor buying and holding shares. The investor also purchases an at-the-money put option on the same stock to protect against a decline in the stock’s value. Most investors think that this strategy can be viewed as a kind of insurance policy that prevents the stock from falling sharply during the period that they hold the shares. A synthetic call is also called a marriage call or protective call.

How a synthetic put works

A synthetic put is an options strategy that combines a short stock position with a long call option on the same stock to mimic a long put option. It is also called a synthetic long put. Essentially, an investor who holds a short position in a stock purchases an at-the-money call option on the same stock. This measure serves to protect against an increase in the share price.

Disadvantages of synthetic options

Even though synthetic options have superior qualities compared to regular options, that doesn’t mean they don’t come with their own problems.

When the market starts moving against a cash or futures position, it loses money in real time. With the protection option in place, the hope is that the value of the option will increase at the same pace to cover the losses. This is best achieved with an at-the-money option, but this is more expensive than an out-of-the-money option. This, in turn, can have a negative impact on the amount of capital tied up in a trade.

Even with an at-the-money option that protects against losses, the trader must have a money management strategy in place to determine when to exit the cash or futures position. Without a loss mitigation plan, traders can miss the opportunity to turn a losing synthetic position into a profitable one.

If the market has little to no activity, the at-the-money option may lose value due to time decay.

Example of a synthetic call

Let’s assume that the price of corn is at $5.60 and market sentiment is long. You have two options: you can buy the futures position and put up a margin of $1,350 or you can buy a call for $3,000. While the outright futures contract requires less than the call option, you face unlimited risk. The call option can limit risk, but $3,000 is a fair price for an at-the-money option. If the market starts to fall, how much of the premium is lost and how quickly is it lost?

In this example, let’s assume a margin discount of $1,000. This special margin rate allows traders to enter into a long futures contract for as little as $300. A protective put can then be purchased for as little as $2,000 and the cost of the synthetic call position is $2,300. Compare this to the $3,000 for a call option alone, when booked that’s an instant savings of $700.

Put-call parity

The reason synthetic options are possible lies in the concept of put-call parity that is implicit in option pricing models. Put-call parity is a principle 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 holding a short put and a long European call of the same class at the same time provides the same return as holding a futures contract on the same underlying asset with the same expiration date and a futures price equal to the option’s strike price corresponds . If the prices of the put and call options differ from each other and this connection does not exist, an arbitrage opportunity exists, which means that experienced traders can theoretically make a risk-free profit. Such opportunities are uncommon in liquid markets and are short-lived.

The equation that expresses put-call parity is: