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In our last Trade Secret Newsletter, we looked at Why Investors Buy or Sell call options. In this month’s issue, from the Montreal Exchange, we will discuss synthetics. Synthetic strategies, which are frequently used by market makers and arbitrageurs, are a combination of instruments—calls, puts and stocks—that allow replicating another strategy. Synthetic Option Strategies The potential returns of a synthetic strategy and a replicated strategy are not necessarily equivalent. The initial costs of each strategy can be quite different. Still, both positions have a profit/loss diagram with an identical curve. The following table summarizes the mostly used synthetic strategies.
For a better understanding of the concept, let’s look at how to replicate a long stock position. Suppose a bullish investor decides to buy 100 ABC shares trading at $55. The investor has a directional risk since he/she will realize a profit if the price of ABC increases (profit unlimited) and will incur a loss if the price of ABC falls under $55 (maximum loss = price paid). There is an equivalent way to replicate this directional position by combining the purchase of one ABC 55 call at $3.40 and the sale of one ABC 55 put at $2.00, for a total debit of $1.40. This combination (long call and short put) is synthetically equivalent to the long stock position of a 100 ABC shares at $55. The following table compares the profit and loss of each position.
Here is the profit/loss diagram of each position.
We must now ask ourselves why would an investor enter into such a strategy? The reason is quite simple: a lower investment. Buying 100 ABC shares costs $5,500 ($55 x 100) while the synthetic strategy only costs $140 ($340 paid for the long call - $200 received for the short put). We must also add a margin deposit with the broker since the put is sold uncovered. However, it is still much cheaper to enter into a synthetic position than to purchase shares. Finally, we want to stress out that you must pay careful attention to some factors. First, the synthetic investor is not eligible to any dividend paid: only the stockholder is. Nevertheless, since the synthetic buyer has invested a lower amount than the long stockholder, he can earn interest by investing the remaining funds. Last, there is a risk of assignment if ABC is lower than the strike price at any time since the put will be in-the-money. To avoid assignment, an investor can establish the strategy with different strike prices: for example, purchase one 55 call and sell one 53 put. This difference provides some room for the price of ABC to fall before the put becomes in-the-money. Source: Montréal Exchange (Mx) - New Options Previous Newsletters
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