Synthetic Long Put Explained

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Synthetic Long Put

A synthetic long put is created when short stock position is combined with a long call of the same series.

The synthetic long put is so named because the established position has the same profit potential as long put.

Synthetic Long Put Construction
Short 100 Shares
Buy 1 ATM Call

Unlimited Profit Potential

The formula for calculating profit is given below:

  • Maximum Profit = Unlimited
  • Profit Achieved When Price of Underlying

Limited Risk

The formula for calculating maximum loss is given below:

  • Max Loss = Premium Paid + Commissions Paid
  • Max Loss Occurs When Price of Underlying = Strike Price of Long Call

Breakeven Point(s)

The underlier price at which break-even is achieved for the synthetic long put position can be calculated using the following formula.

  • Breakeven Point = Sale Price of Underlying – Premium Paid

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Synthetic Options Explained

One of the interesting features about options is that there is a relationship between calls, puts, and the underlying stock. And because of that relationship, some option positions are synthetic to others. The prices of put and call options have an identity relationship through the concept of put-call parity.

Some option combinations are easier, or less costly to trade than others. Which means less slippage and less commissions.

Here are few examples of synthetic options positions.

Synthetic Long Stock

Among the many options strategies, one of the most interesting is synthetic long stock . This combines a long call and a short put opened at the same strike and expiration. The name “synthetic” is derived from the fact that the two positions change in value dollar for dollar with changes in 100 shares of stock.

Synthetic Long Stock Construction
  • Buy 1 ATM Call
  • Sell 1 ATM Put

This is an unlimited profit, limited risk options trading strategy that is taken when the options trader is bullish on the underlying security but seeks a low cost alternative to purchasing the stock outright.

Synthetic Short Stock

The synthetic long stock is a low-risk, highly leverage strategy. But for synthetic short stock, the risk profile is completely different. For the synthetic long, the combination consists of a long call and a short put, at the same strike, and at the same expiration.Reversing the positions to short call and long put creates a synthetic short stock, and completely changes the risk.

Synthetic Short Stock Construction
  • Buy 1 ATM Put
  • Sell 1 ATM Call

This is a limited profit, unlimited risk options trading strategy that is taken when the options trader is bearish on the underlying security but seeks an alternative to short selling the stock.

Synthetic Long Call

A synthetic call, or synthetic long call, is an options strategy in which an investor, holding a long position in a stock, purchases an at-the-money put option on the same stock to protect against depreciation in the stock’s price. It is similar to an insurance policy.

Synthetic Long Call Construction
  • Buy 100 Shares
  • Buy 1 ATM Put

This is an unlimited profit, limited risk options trading strategy. A synthetic call is also known as a married put or protective put. The synthetic call is a bullish strategy used when the investor is concerned about potential near-term uncertainties in the stock. By owning the stock with a protective put option , the investor still receives the benefits of stock ownership, such as receiving dividends and holding the right to vote. In contrast, just owning a call option , while equally as bullish as owning the stock, does not bestow the same benefits of stock ownership.

Synthetic Long Put

By combining a long call option and a short stock position, the investor simulates a long put position. A synthetic put is also known as a married call or protective call.

Synthetic Long Put Construction
  • Sell 100 Shares
  • Buy 1 ATM Call

This is a limited profit, limited risk options trading strategy. The synthetic put is a strategy, used when the investor has a bearish bet and is concerned about potential near-term strength in the underlying stock. It is similar to an insurance policy except that the investor wants the price of the underlying stock to fall, not rise. The strategy combines the short sale of a security with a long-call position on the same security.

Other Equivalent Positions

The basic equation that describes an underlying and its options is: Owning one call option and selling one put option (with the same strike price and expiration date) is equivalent to owning 100 shares of stock. Thus,

S = C – P; where S = stock; C = call; P = put

There are some other options positions that can be considered equivalent. For example, take a look at a covered call position (long stock and short one call), or S-C.

From the equation above, S –C = -P. In other words, if you own stock and sell one call option (covered call writing) then your position is equivalent to being short one put option with the same strike and expiration. That position is naked short the put. Amazingly some brokers don’t allow all clients to sell naked puts, but they allow all to write covered calls. But as we can see, writing a covered call is equivalent to selling a naked put.

Summary

Synthetic positions can be used to change one position into another when your outlook changes. Options offer enormous flexibility in positioning. Synthetics can offer an alternative plan B, require less capital, eliminate the need to borrow the stock if selling it short etc. It is essential to understand synthetic options in order to fully utilize the flexibility of options.

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    Understanding Synthetic Options

    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 offer a low-cost way to make an investment with less capital.

    While options have the ability to limit a trader’s total investment, options also expose traders to volatility, risk, and adverse opportunity 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 profit with limited risk.

    However, this safety net comes with a cost because many studies indicate the vast majority of options held until expiration expire worthless. Faced with these sobering statistics, it is difficult for a trader to feel comfortable buying and holding an option for too long.

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    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 are paying too much or 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 understanding what makes one option strike price better than another strike price. Once a strike price is chosen, it is a definitive financial commitment and the trader must assume the underlying asset will reach the strike price and exceed it to book a profit. 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 direction but picks the wrong strike price.

    Synthetic Options

    Many problems can be minimized or eliminated when 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, adverse statistics can work in a synthetic’s favor because volatility, decay and strike price play a less important role in its ultimate outcome.

    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. 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 positions and therefore require a lower margin. 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, a synthetic option has the ability to give traders the best of both worlds while 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 an at-the-money put 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.

    How a Synthetic Put Works

    A synthetic put is an options strategy that combines a short stock position with a long call option on that same stock to mimic a long put option. It is also called a synthetic long put. Essentially, an investor who has a short position in a stock purchases an at-the-money call option on that same stock. This action is taken to protect against appreciation in the stock’s price. A synthetic put is also known as a married call or protective call.

    Disadvantages of Synthetic Options

    While synthetic options have superior qualities compared to regular options, that doesn’t mean that they don’t generate their 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 option but they are 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, he or she 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 risk but 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 lost and 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 the cost of the synthetic call position becomes $2,300. Compare this to the $3,000 for a call option alone, booking is 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 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 simultaneously holding a short put and long European call of the same class will deliver the same return as holding one forward contract on the same underlying asset, with the same expiration, and a forward price equal to the option’s strike price. If the prices of the put and call options diverge so that this relationship does not hold, an arbitrage opportunity 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:

    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: simplify decisions, make trading less expensive and help to manage positions more effectively.

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