Wednesday, May 13, 2009

Calls vs. Married Puts

So let's pick up on Tuesday's synthetics post with an in depth look at long calls vs. married puts.

Remember, the basic formula for synthetics is:
S = C - P

If we swap this around we could say that:
C = S + P

In other words, a Long Call is the synthetic equivalent of a Married Put (long stock + long put), when the call & put have the same strike & expiry.

I'm going to use MSFT, which was highlighted on Friday's Options Action, as an example.

In contemplating a bullish type trade on MSFT, our Options Actions pals pointed out that implied volatility on MSFT options was relatively low. Take a look at the IV-HV chart.
Current IV (gold line) is at 35%, while 30 day Historical volatility (blue line) is at 46%. Although MSFT IV has come in drastically over the past few months, it's not really an isolated incident as IV has come in on just about everything (take a glimpse of the VIX). Although IV seems cheap compared to 30 day HV, 10 day HV (not shown)is at a mere 24%... So not sure if options are a definite buy here, but we must admit they're the cheapest they've been since back in September 2008.

Remember when IV is low, options are relatively cheap & potentially under priced. When IV is high, options are relatively expensive & potentially overpriced. B/c of the low IV, *cheap* options, they compared buying straight calls to buying puts (for those already long the stock).

MSFT is currently trading at $19.75- Let's compare buying the July 17 calls vs. owning the stock & buying a July 17 put.

Long calls
17 Jul call @ $3.00
Net Debit/ Max Risk = $3.00
Max Reward = Unlimited

If at expiry the stock is below $17, the call will expire worthless resulting in a $3.00 loss.

Married Put
Long 100 shares stock
Buy 17 Jul put @ $.35
Net Debit/Max Risk = (19.75 - 17) + .35 = $3.10
Max Reward = Unlimited
If at expiry the stock is below $17, I can exercise my put and sell my stock at $17 resulting in a $2.75 loss on the stock. I will also lose $.35 of extrinsic value on my put option resulting in a total loss of $3.10 - roughly the same amount as the long call.

Although the risk-reward characteristics are identical, the Married Put obviously costs more due to purchasing 100 shares of stock. As a result most would prefer to simply buy the call option.
The biggest benefits I see with understanding synthetic relationships is it allows me the ability to trade more efficiently and find lower cost alternatives. As discussed, a few examples would be-
1. Naked Put instead of Covered Call
2. Long Call instead of Married Put
3. Put or Call Spread instead of a Collar


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