Option Synthetics are constructed with stocks and options to allow traders to leverage and at the same time not worry about external factors such as volatility. Synthetics can be implemented as a tool for both long or short positions. In this article, we will explore how option synthetics work, the different types available, and when you should use them in your trading strategy.
What are Option Synthetics
Synthetics is a way of fabricating artificial positions using stocks and options which has the same risk and reward as the real position. For example, Is there a different way to construct a stock position using calls and puts?
So Why Option Synthetics? Let say we do stock trading. We can take advantage of the stock price rises by buying the stock and stock price declines by selling the stock ( selling the stock involves risks and margins). Options provide us alternative to simulate stock trading with leverage for both upside and downside price moves. In the next section, we will cover the basics of option synthetics.
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Option Synthetics basics
Before we get to this , we need to lay down a few basics regarding option greeks.
Stock is pure delta. For a stock, delta is 100% which is so obvious, isn't it
The sum of deltas of the call and put options for the same stock price is alway 100.
Vega, theta and gamma are for the strike price and not related to individual call and put options. In a nut shell, these greeks carry the same values for the calls and puts of the same strike price.
Now, how are stock and options related
Let us say the price of the $APPL stock is at 100$. The stock can be synthetically constructed using the following formula
Stock = Call - put
Where call and put are at the strike price 100 ( closest to the current price). A stock can be synthetically constructed by buying a call and selling a corresponding put. It is very important that the call and put selected are for the same strike price and expiration and close the price of the stock. Why this would work? As mentioned above,
Gamma, theta and vega are for strike price and have positive values for a long call and negative values for the short option and hence they get cancelled.
we have only delta left when we buy a call and short a put. When we buy a call, we are long delta and when we short a put , we are more long delta. Once we add these deltas, it becomes 100 which is equal to the delta of a stock.
Sometimes there could be disparity between the option prices and stock and could lead to arbitrage trading opportunities which is very rate in liquid markets.
Option Synthetics types
Using the formula above, lets see how we can synthetically construct long stock position , short stock position, long synthetic call position, Short synthetic call position, long put position, short put position
Long Stock position : Call - put ( Buy a call and sell a put)
Short stock position: put- call (Buy a put and sell a call)
Long call position: stock+put ( Buy a stock and buy a put)
Short call position: -stock -put ( sell stock and sell a put)
Long put position: call - stock ( Buy a call and sell a stock)
Short put position: -stock -call ( sell a stock and sell a call)
Why trade option synthetics
Synthetics only deal with delta and is not affected by volatility and time decay as mentioned above.
The traders do not need to worry about keeping track of the option greeks such as vega, theta and gamma for entering the trade and can only keep track of their net position deltas. Position delta is the term given to the total delta in the portfolio ( including stocks and options)
Traders may not see their positions become worthless like in naked options but still may sustain losses if the position moves against the direction traded.
Synthetics can also allow you to hedge your portfolio by doing synthetic short stocks for much cheaper price.
Also, Synthetic calls and puts have better margins with brokers than normal selling puts as it involves a stock position and is little risky than just options.
Final Thoughts
It is always good to know of more than one way to construct your portfolio. Synthetics can be used in the portfolio to take advantage of options leverage and also to hedge considering the lower margins for synthetics. Today, even in the crypto world, we have synthetics like SNX, INS that let you simulate the trading of equities using tokens but works in a different way though.
The biggest advantage of synthetics is that the traders do not have to worry about the options getting worthless at the time of expiration ( Volatility and time decay are taken out in this strategy). However, the traders still need to use some kind of technical analysis to get the direction bias of the equities along with markets and evaluate other option strategies to earn consistent profits and minimize losses.
If you like this post, you might also like options trading strategies for crash-proof portfolio. Also, did you know that Breakout trading strategy is one strategy that can be used for trading cryptos, stocks, options, and other derivatives and gives you the best risk-reward ratio (RRR) for the trades placed?
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