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聽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聽traders to volatility, risk, and adverse聽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,聽the maximum that can be lost is $500. A defining principle of an option is its ability to provide an unlimited opportunity for profit聽with limited risk.

However, this safety net comes with a cost聽because many聽studies indicate the vast majority of options聽held until expiration expire聽worthless.锘匡豢锘 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鈥delta, gamma, vega, theta, and rho鈥攎easure 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聽paying too much聽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聽what makes one option strike price better than another聽strike price. Once a聽strike price is chosen, it is a definitive financial commitment and the trader must assume the underlying asset will reach聽the strike price聽and聽exceed it to book a聽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聽but picks the wrong strike price.

Synthetic Options

Many problems can be minimized or eliminated when a trader聽uses聽a synthetic option instead of purchasing a vanilla聽option. A synthetic option is less affected by the problem of options expiring worthless; in fact, adverse聽statistics can work in a synthetic's favor because volatility, decay and strike price play a less important role in its聽ultimate outcome.

There are two types of synthetic options: synthetic calls and synthetic puts. Both types聽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.锘 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聽and therefore require聽a lower聽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聽synthetic option聽has the ability to give traders the best of both worlds聽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聽at-the-money聽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. 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 a聽short聽stock position with a聽long call option聽on that same stock to mimic a聽long put option. It is also called a synthetic long put.锘 Essentially, an investor who has a short position in a stock purchases an聽at-the-money聽call option on that same stock. This action is taken to protect against appreciation in the stock's price.锘柯

Synthetic Put
Image by Julie Bang 漏 Investopedia 2019

Disadvantages of Synthetic Options

While synthetic options have superior qualities compared to regular options, that doesn't mean that they don't generate聽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聽but they聽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聽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聽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聽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聽cost of the synthetic call position becomes $2,300. Compare this to the $3,000聽for a call option alone, booking聽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聽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聽forward contract聽on the same underlying asset, with the same expiration, and a聽forward price聽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聽arbitrage聽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:

C+PV(x)=P+Swhere:C=price聽of聽the聽European聽call聽optionPV(x)=the聽present聽value聽of聽the聽strike聽price聽(x),discounted聽from聽the聽value聽on聽the聽expirationdate聽at聽the聽risk-free聽rateP=price聽of聽the聽European聽putS=spot聽price聽or聽the聽current聽market聽value聽of聽the聽un-\begin{aligned}&C+PV(x)=P+S\\&\textbf{where:}\\&C=\text{price of the European call option}\\&PV(x)=\text{the present value of the strike price } (x),\\&\qquad\qquad\ \,\text{discounted from the value on the expiration}\\&\qquad\qquad\ \,\text{date at the risk-free rate}\\ &P=\text{price of the European put}\\&S=\text{spot price or the current market value of the un-}\\&\qquad\text{derlying asset}\end{aligned}C+PV(x)=P+Swhere:C=price聽of聽the聽European聽call聽optionPV(x)=the聽present聽value聽of聽the聽strike聽price聽(x),discounted聽from聽the聽value聽on聽the聽expirationdate聽at聽the聽risk-free聽rateP=price聽of聽the聽European聽putS=spot聽price聽or聽the聽current聽market聽value聽of聽the聽un-

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