February 10, 2005

Introduction to Synthetic Trades Using Options
by John Brasher, CallWriter Publisher

The title sounds really boring, doesn't it? Have no fear, though, it's actually kind of interesting. The modern world offers a seemingly endless supply of synthetic things, so it only makes sense that there are also synthetic trades. Today's issue looks at how some basic synthetic positions are created and how they compare to the trades they mimic.

When referring to options, synthetics are positions that are made up of two things to act like a third. That is, you can create a "synthetic" long call by buying stock and buying a put. You can sell "synthetic" stock short by selling a call and buying a put with the same strike price. In the world of stock and stock options, there are three building blocks:

• Stock
• Call Options
• Put Options

For those of you who are not yet fluid with stock option concepts, remember that a call option (or "call") gives its holder the right, but not the obligation, to buy a specified stock at a specified price for a fixed period of time. The put option (or "put") gives its holder the right, but not the obligation, to sell a specified stock at a specified price for a fixed period of time. A trade will be long or short. A short position is one in which the stock or option is sold by the trader, and a long position is one in which the trader buys the stock or option. Short and long positions can be combined in the same trade, as the strategies discussed in this article illustrate.

These three simple elements of stock, call and put can be bought or sold on their own (and buying and selling each is a strategy in and of itself), and they can be combined in numerous ways to create different positions.

The Basic Synthetics

A synthetic position (or synthetic) is one that mimics, but is not the same as, another position constructed of different elements. The synthetic in many ways acts the same as the other position it mimics in that it wins and loses the same. This means it has the same risk-reward profiile. The basic synthetic equivalents are:

The Long Stock - Long Combo Example

There are many others, but the basic synthetics are the best known and easiest to understand. So is a synthetic the same as the other position of which it is a synthetic? No. It behaves the same in many ways, but it is never the same position. A good example is the long stock/long combo synthetic, the first one described in the table above. While the long combo (long call + short put) is synthetically the same as buying stock, the stock buyer owns the underlying stock, for better or worse. Stock does not expire. Puts and calls do. When expiration day comes, the long call expires, but the stock still exists. The stock buyer can sell the stock, hold it, even write calls against it, at his or her whim. Since the long call evaporates at expiration, the price paid for it will be forfeited unless the combo holder exercises the call or sells it while it still has some value.

So why create a long combo? For one thing, creating it is much cheaper than buying the stock, since the sale of the naked put basically pays for the purchase of the long call. The major risk in long option positions is that the stock does not make the desired move on time, resulting in a loss of most or all of the premium paid for the option. However, the long combo essentially is a flat position at entry (not a debit position), because the put sale pays for the call buy. Thus if the stock does not make the expected move by expiration, the long combo holder is out little or nothing. Now, are synthetics looking just a tad less boring?

The long combo holder faces the risk that the underlying stock will go to zero, which is the maximum loss one can realize on a short put. In fact, this is one of those option boogey-man examples used to show how dangerous options supposedly are. However, the stock purchaser is facing precisely the same risk!

Example:  Suppose I buy the stock at $20, but you instead sell the 20 Put naked for a $1.00 premium and buy the 20 Call for a $1.00 premium. Assume that the stock then plummets overnight and gaps down to $10 on option expiration day. I sell the stock for a $10 loss, and you likewise take a $10 loss, since the stock is put to you at $20 and you sell it for $10. Does it really matter that the stock got me and a long combo got you? Was your exposure from selling the naked put any greater than mine from buying the stock? Absolutely not. Yet by purchasing the call as part of the long combo, you stood to profit as much as I did had the stock advanced as hoped before expiration.

So which was wiser... the long stock or the long combo? The answer is that neither is better or wiser. It depends on your trading objectives. It depends on how much cash you want to put into a trade. And it also depends on the approval level your broker has granted your options account. If you are a new or inexperienced trader, you might not have a high enough approval level to write naked options, or even to buy options.

Why sell the put?  The question arises in a long combo... why sell the put at all? If one just buys the call, the major exposure from the naked put in the event the stock tanks is not there, and the risk in the trade is limited to the amount paid for the call. Good question. First, to mimic a stock purchase, the trader has to sell the put. Just buying calls is a different strategy and has a different risk profile. Second, the sale of the put basically pays for the call. Unless you are really good at timing stock movements, you will lose a lot of money on long calls when they expire worthless. In that regard, the premium from selling the put lowers your risk. Third, even though option texts refer to buying calls as a "limited risk" trade, the fact is that if you lose the entire premium paid for the calls, it is a 100% loss. And 40-50% losses in long calls are common. Others are free to disagree, but I don't view these as "limited" losses.

Why Synthetics?

Why do we care about synthetics at all? The main reason is that synthetics provide a mechanism to put on a trade more cheaply. As in our long combo example above, it is vastly cheaper to create a long combo than to buy the stock, because the long combo generates a very small net debit to put on, or even a small credit. Synthetics are not better in any sense; they are just another way of accomplishing the trade objective.

By way of example, let's look instead at the covered call trade, which really is just a synthetic way of writing a naked put. A covered call requires that the trader buy the stock in order to sell the calls. The naked put by contrast, simply requires that the trader sell the put, although the broker will impose a margin requirement (the minimum margin requirement is 20% of the stock price at trade entry, plus the put premium, less the amount the put is OTM, although brokers can require more margin). Thus naked puts will always require an initial margin that is much smaller than the cash outlay necessary to write a covered call; generally the margin required will only be 25-35% of the price of the stock.

Example:  To write the 20 Call on a $19 stock, receiving a $1.00 premium, would requre a cash outlay of $18 per share. Selling the naked 17.5 Put on the same $19 stock for a $1.00 premium would require a minimum margin of only $3.30 per share ( [.20 x 19.00] + 1.00 - 1.50 ). Obviously, one can write a lot more naked puts than covered calls against the same trading capital. However, traders selling puts should not forget the downside risk involved and be led into exposing their accounts to excessive risk.

Here are some of the reasons different traders might prefer the naked put to the covered call, or vice-versa:

• Jill sells puts naked because she thinks it is pointless to tie up money in stock in order to run a covered call trade.
• Jack does not have a large account and is able to run more or larger trades using naked puts than would be possible if he had to buy the stock.
• Jane might on the other hand simply prefer the flexibility of owning the stock in the covered call trade, or just be more comfortable buying the stock. After all, the stock does not expire, and there are opportunities to manage the stock after expiration day, if it is not called out.
• Joan has a low options account approval level, which permits covered calls but does not permit her to write naked puts.
• Jim likes the fact that naked puts expire, for good or ill, and the strategy never requires continued management after expiration day.
• Jan likes the fact that only one commission is paid to open and one to close the naked put trade.

The risk profile of both trades is virtually identical, but not perfectly identical. Why? One reason is that the two trades offer different management possibilities. If the underlying stock is OTM at expiration, it will not be called out, and the trader will continue to own the stock. This allows the trader to write more calls, or wait for a better price. By contrast, the naked put evaporates at expiration, and the loss or gain is realized. The naked put writer in trouble can buy a put in order to turn the naked put into a put spread, which might at least limit a potential loss. But the put writer's only option at expiration when the trade is in trouble is to roll the put out to a further month, assuming an improvement in the stock price is foreseen. Another reason is that the naked put writer for safety needs to write puts that are OTM. Thus on the same stock, naked put writers and covered call writers would not sell the same strike unless the covered call writer created a deep ITM trade. So for example, on a $20 stock, naked put writers would not usually sell the 20 Put. The risk profiles of the two trades would be very close, indeed, if both the put writer and covered call writer sold the 20 strike - but still not quite identical.

In deciding whether to write naked puts or covered calls, there is no right or wrong choice. There is only what is right for the individual trader, which really comes down to individual preferences. However, every trader should know how to synthetically achieve the desired trade, so that there is a choice in the first place.

More Synthetic Fun

Remember that I said above it is possible to use any two of the three elements to synthetically create the third? Here are some more examples:

Now you know about synthetic trades created using stock and options. They provide real food for thought, and they are actually rather entertaining. More to the point, they can come in handy!

Good luck and good trading!