As any fashion professional would tell you, though your collection of outfits provides the base of your wardrobe, the accessories—those extra little add-ons—can make the difference.
If we were to draw a parallel to the options market, the base would consist of your typical options strategies—single-leg options, verticals, straddles, strangles, and such—that make up the core of our daily Swim Lessons shows.
And then there are the “accessories”—those little tips and tricks that sophisticated options traders often use to pursue their trading objectives. We would put synthetics in that category.
The following, like all of our strategy discussions, is strictly for educational purposes only. It is not, and should not be considered, individualized advice or a recommendation.
The Fiber of Synthetics
A synthetic is a position that mimics the risk/reward profile of another position by using some combination of options and the underlying. Synthetics can come in handy in a number of situations, so it may be important to gain an understanding of them.
Let’s start with a basic synthetic position. Suppose you’re long one call and short one put of the same strike and expiration date, then you have a position that has the same risk/reward profile as owning 100 shares of the underlying. Why? This is part of something called put-call parity, which helps define how calls, puts and the underlying all fit together. By mixing and matching any two, in the correct manner and ratio of course, you have a position that mimics the third. See figure 1 for the six basic synthetic positions. And why 100 shares? One options contract gives the owner the right to buy (call) or sell (put) 100 shares of the underlying asset.
FIGURE 1: SIX BASIC SYNTHETICS.
Options traders can mimic the risk/reward profile of another position by using any of these six combinations.
So let’s go back to that long call/short put example. At expiration, if the price of the underlying is above the strike, you’ll likely want to exercise your call. If it’s below the strike, you’ll likely be assigned the put. Either way, you’ll end up buying a long stock position at the strike price. In other words, you could say this combined option position has a delta of 1.00. It’s a position that’s going to give you the same risk/reward profile as a long position in the underlying, regardless of where the underlying is trading at expiration. So it’s a synthetic long underlying trade.
In fact, if you’ve ever bought stock or an ETF, you had a position with the same risk/reward profile as a synthetic option position comprised of a long call and a short put. If you are a TD Ameritrade client, you can use the Risk Profile tool in the thinkorswim® platform to see for yourself.
What happens if you buy a put to help provide a measure of protection for a long stock position you have? You end up with a position with the same risk/reward profile as a long call position with the same strike as your put. See figure 2.
FIGURE 2: COMPARISON OF POSITIONS.
Top chart shows one long 100-strike call. Bottom chart shows the synthetic position made from one 100-strike put and 100 shares of long stock. Note that the risk profile is the same. Chart source: The thinkorswim platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
When to Accessorize with Synthetics
Synthetics can come in handy in a number of situations, which we often feature in our Swim Lessons show. For example, suppose you have owned a certain stock in your portfolio for quite a number of years, it has appreciated considerably, and you’re thinking it might be about to retrace, so you’d like to sell it, and perhaps buy it back at a later time. But selling the stock might be a taxable event. One idea would be to put on a synthetic short position by buying a put and selling a call. And if your target price is met, you can likely liquidate the options positions, keeping your long stock position intact.
Or let’s say you’re interested in initiating a buy-write, which is a covered call strategy consisting of the purchase of stock and the sale of a call option. Instead of making those two trades, you could get the same risk/reward profile in one trade by just selling a cash-secured put.
What if you want to short a stock but can’t, or don’t want to, go through the borrow process? A synthetic short stock position might be the answer.
These are but a few of the situations in which a synthetic position might be useful.