Simply Synthetic
I had a lot of interesting comments about my article last week when I discussed how the Covered Call and the Short Put had the same risk and P/L profile. Several people said that when they were doing Covered Calls they made money, but when they did the Short Puts it didn't work out so well. Well, a little investigation goes a long way! From what I can determine, the same person who would feel uncomfortable buying more than 500 shares of stock and selling 5 Calls against them, should not feel comfortable selling 25 Puts naked. Right away, we're comparing 500 shares to the equivalent of 2,500 shares. Another point is that for the 2 positions to be equivalent the Puts must be at the same strike and expiration as the Calls. Otherwise, you're comparing 2 positions that may be very different, like Ferrari versus Lamborghini.
Anyway, the concept of synthetic positions is extremely important and I'm going to cover them in a little more detail. Let's start off with a definition.
Definition: A "Synthetic Position" is a position consisting of options and possibly stock that in combination has the same risk profile and characteristics of another position. The 2 positions would be described as being synthetically equivalent. The Greeks of the actual and synthetic positions will be almost identical and the total amount of dollars gained or lost, i.e. P/L, will be very similar. The percentage rate of return on a synthetic position however may be very different than the return on the actual position, since the amount necessary to establish the 2 positions may also be very different. That comment will be clearer after you see the example of synthetic versus actual long stock later in this article. Other differences between synthetic and actual positions relate to the amount of margin required to put on the positions and how they are taxed.
There are many different synthetic positions, but for now, we're going to concentrate on the 6 basic ones. These are called synthetic equations:
Notice that the last position is equal to the Covered Call. Also, the 3rd position Long Stock and Long Put is referred to as the Married Put.
Next, we take can take a look at the graphs of the synthetic versus actual positions. I trust that you remember the generic graphs of the 6 basic positions. If you need a refresher take a look at my article titled "A Graph is Worth a Thousand Words" from January 31, 2008. I suggest that you study these positions. In time, they will become second nature to you.
What's actually going on here is that we're adding the 2 graphs on the right to come up with the graph on the left. It's a concept that most people are not familiar with. When I mentor traders, I cover the rules for adding graphs in great detail, but some of that is beyond the scope of this article.
Alright, so what do we have so far? I've put together some algebraic equations and shown you some arcane way of adding graphs together, but I know what you're thinking, "show me the money." Fair enough. How about I'll prove 1 of the equations numerically, and then you take my word on the other 5.
With XYZ stock trading at $55, let's construct 1,000 shares of synthetic stock by buying 10 of the May 60 Calls and shorting 10 of the May 60 Puts. By the way, I could have chosen any strike or expiration, but they have to be the same for both the Puts and Calls. I'll use a risk free rate of return of 5% (a little high in this environment, but it keeps the arithmetic simple), and we'll assume 35 days to expiration. On that basis, the theoretical values for the Put and Call are $6.08 and $1.37, respectively.
Notice how the results are the same (ignore the $3 differences due to rounding) no matter where the stock is at expiration! So with only $1,370 of cash for the Calls and $17,080 of available margin to cover the short Puts, you can have the same results as if you bought $55,000 of stock. It makes me wonder why stock traders don't just trade options instead!?
If you really want to understand what's going on, I recommend that you do the same type of analysis for some of the other synthetic positions. You have all the information you need. If you get stuck, or it doesn't seem to work, let me know, I'll be happy to help out.
As always, if you have any questions about my articles, have suggestions for future topics, or want more information about our options mentoring program, feel free to email me at: SFreifeld@tradingacademy.com or call me at: (888) OTA-2580 ext. 2010.
11. Know Thy Options!
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Stan Freifeld comes to us from the Floor of the American Stock Exchange where he traded options for his own account from 1994-2001. He was a Market Maker for the options on several popular equities including Dupont, Schering Plough, Walgreen's, CBS, U.S. Surgical and Biovail.When he is not trading or thinking about trading, Stan relieves his stress by playing competitive squash, competing in local road rallies with his Ferrari Cabriolet and tutoring local high school students for the SAT's. The bottom line is that Stan, a long time MENSA member, is an engaging teacher with an extraordinary background in options trading and risk management. He is helpful and patient by nature and equally at ease with all levels of traders, from complete novices to advanced pros and academics. He'll be happy to teach you to trade!