Tuesday, May 12, 2009

Synthetics

Friday's Options Action included a conversation on equivalent positions, such as married puts vs. long call trades. Understanding equivalents or synthetics is quite useful when playing in the options realm. Synthetics have identical risk-reward characteristics, thus one can be used as a substitute for the other. For example:

1. Covered Calls & Naked Puts can be synthetics
2. Long Calls & Married puts can be synthetics
3. Long Stock & Long Call/ Short Put combo can by synthetics

Basic Equation:
Let's look at a few formulas to illustrate. For the following formulas S = Stock, C = Calls, P = Puts. P & C must represent the same underlying and have the same expiry date & strike price for the formula to hold true.

S = C - P

One can create a synthetic long stock position by buying a call (C) and selling a put (-P). For example:
Long 100 shares SPY @ $91 = Long 91 June call + Short 91 June put

The equation holds true because at expiration if SPY are above $91, the 91 put expires worthless, the 91 call is assigned and I buy 100 shares @ $91. If SPY is below $91, the 91 call expires worthless, the 91 short put is assigned and I go long 100 shares @ $91. Regardless of the stock price I will be long 100 shares SPY @ $91! Take a look at the risk graphs:


We could use a little algebra and change the formula:

S = C - P

S - C = - P In other words, S - C (covered call) = -P (Short Naked Put). This is again assuming the call and put are the same strike with the same expiry date.

I've already discussed naked puts here.

Here's another:

S = C - P

S + P = C In other words, S + P (Married Put) = C (Long Call option)

This formula brings us back to the subject at hand. A married put can be considered a synthetic long call. In my next post, I'll elaborate on Married Put vs. Long Call trade on MSFT.
Tyler-

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