Two definitions of the word “synthetic” are:

- produced artificially
- devised, arranged, or fabricated for special situations to imitate or replace usual realities

These definitions can describe “Synthetic Positions” in option trading. To understand synthetic option positions (or “synthetics”), we have to understand the basic relationship between puts and calls:

K + C = U + P + I – D

Where

K = Strike Price

C = Call

U = Underlying stock price

P = Put

I = Interest

D = Dividends

For most situations, we can assume interest and dividends are small enough to ignore. We will simplify our equation by excluding them. There are situations where interest and dividends do affect this equation such as high interest rates, long time periods or large dividends for example.

Simplifying our equation, we now have

K + C = U + P

Since the strike price is arbitrary and a constant, let’s remove it from the equation to see what the relationship is between the Call, Put and Underlying security price boils down to:

C = U + P

Long is positive and short is negative. So we have

- +C = Long Call
- -C = Short Call
- +P = Long Put
- -P = Short Put
- +U = Long Stock
- -U = Short Stock

This simple equation let’s you derive the six synthetic relationships quite quickly.

Think back to your algebra class and solve what synthetic you need by putting that variable alone on one side and moving the rest to the other side of the equation. Change the sign when moving from one side to the other of the equation (“jumping the fence as my 8th grade teach used to say”).

**We can now show the six basic relationships**, solved using basic algebra. They are:

- Long Call = Long Stock + Long Put (C = U + P)
- Short Call = Short Stock + Short Put (-C = -U – P)
- Long Put = Long Call + Short Stock (P = C – U)
- Short Put = Short Call + Long Stock (-P = -C + U)
- Long Stock = Long Call + Short Put (U = C – P)
- Short Stock = Short Call + Long Put (-U = -C + P)

**How can we use this knowledge?**

**Hedge an existing position.**

Suppose you have a covered write on a stock but earnings are coming out and you’re worried the stock price might jump around a lot. Or you are going on vacation and don’t want to worry what the market is doing while you’re gone.

Since you know a covered write is identical to a short put synthetically, if you buy a long put, that should completely offset your covered write and completely hedge you while you go through earnings. No need to sell your stock and buy in your short call. Just buy a put. Here’s how that would look:

Notice how the blue line is completely flat. That’s the combined position of the long stock, short call and long put.

**Reverse Market Directional Bias quickly**

Suppose you are bullish on the market and have a Long Call. You change your mind and decide you should be bearish. If you sold your long call and bought long puts, you would have two commissions and two sets of slippage to deal with. Since we know a Long Put = Long Call + Short Stock, all we have to do is SHORT THE STOCK. This changes your position to a synthetic Long Put with one transaction.

This technique is also VERY useful in very fast market conditions. Option bid/ask spreads can really widen during fast markets so your fills closing your Long Call and buying your Long Put might really put you in a hole starting out. Since stocks are very liquid and have very tight bid/ask spreads normally, shorting the stock is a very useful tool to convert your Long Call position during a fast market.

**Closing a position with illiquid options using a box**

This happened to me trading 30 Year Treasury Bond futures options (ZB contract) a few years ago. The bid/ask spread of the in-the-money options was really crazy. (Bid $4, Ask $6 for example). I had a profit in a position that had started out as a butterfly. I could close most of the position with good fills; however, I had some ITM options with very unfavorable bid/ask spreads. What did I do? I built a box!

I had these options I needed to close:

- A long Put at 118 Strike
- A long Call at the 113 strike

To create a riskless position, I did the opposite:

- Short Call at the 118 Strike
- Short Put at the 113 Strike

I ended up with:

- A long Put + Short Call at the 118 strike = a synthetic Short Stock position
- A Long Call + Short Put at the 113 strike = a synthetic Long Stock position
- Which means I was synthetically Long AND Short the stock (which means there’s no risk left)

I hope you’ve seen how useful synthetic option positions can be. There’s more variations but as long as you understand the basic formula of

Long Call = Long Stock + Long Put

You can re-arrange the equation like in algebra class to put the one variable you need by itself and everything else on the other side of the equation to see what the synthetic is.

Are you using synthetics in your trading?

]]>**Today you will learn about a basic synthetic option position called the synthetic long stock position.**

You can create a synthetic long stock position to replicate and replace buying stock outright. You also can create a synthetic short stock position to replicate and replace selling stock outright.

A synthetic long stock position is created when you purchase one at-the-money call option and sell one at-the-money put option at the same strike price and same expiration cycle. The position represents buying 100 shares of the underlying.

If you would like to create a larger position, the call and put options must be at a one to one ratio.

Both the synthetic long stock and the synthetic short stock strategy have the potential to reduce margin requirements for you.

A synthetic long stock position can be entered as a debit or a credit. Whether or not you pay a debit or receive a credit to enter the position can depend upon where the price of the underlying is trading in relationship to the option strike price you are using to create the position.

**A Risk Graph is helpful to visualize
the similarities between traditional long stock and synthetic long stock…**

A Risk Graph shows many important items. One of those items is how the movement of the price of the underlying will affect the underlying’s value.

Do you want to learn more about the risk graph? If you do, here’s a risk graph tutorial from Think or Swim.

To understand the relationship between a traditional long stock position and a synthetic long stock position, let’s take a look at a risk graph showing each position.

Here’s a risk graph of AAPL traditional long stock…

**Figure A: 100 shares AAPL Traditional Long Stock**

This risk graph is showing the price of AAPL is currently 193.90. Let’s assume you purchased the stock at the current price 193.90.

If the underlying price increases, it will be indicated on the diagonal red line. If the underlying stock stays above the 193.90 the stock position will show a profit.

If the underlying moves down below the 193.90 entry price, the long stock position will show a loss. This loss will be indicated on the red diagonal line.

You must include your commission costs to determine your actual profit or loss.

**Here’s an example of a synthetic long
position…**

Figure B: AAPL Risk Graph Synthetic Long Stock Position

This is a risk graph showing an AAPL synthetic long stock position. This position was created by purchasing an at-the-money 21 DEC 18 195 long call option and selling an at-the-money 21 DEC 18 195 put option.

As you can see, both options have the same strike price and the same expiration cycle.

Please notice the diagonal line which indicates the profit and loss of the stock.

Do you see how the synthetic long option position has a similar risk profile when compared to the 100 shares of AAPL risk graph in Figure A?

**How is a Synthetic Long Stock Option
position constructed?**

At the same time at the same strike price and the same expiration date;

- Buy 1 at-the-money (ATM) Call option
- Sell 1 at-the-money (ATM) Put option

**How to calculate the profit of a
synthetic long stock position is shown below:**

There is unlimited profit potential up to the expiration date of the options.

- If the position is entered as a debit:

Profit = Underlying Price minus Strike Price of the Long Call minus the net debit you paid if the trade was entered as a debit minus commissions.

**For Example:**

110 (underlying price) – 105 (strike price) – $2 (debit paid) – $1 (commissions)

= $2 (profit)

- If the position is entered as a credit;

Profit = Underlying Price minus Strike Price of the Long Call plus the net premium/credit you received minus commissions.

**For Example:**

110 (underlying price) – 105 (strike price) + $3 (credit) – $1 (commissions)

= $7 (profit)

**What is the potential risk in a synthetic long stock position?**

Just as a traditional long stock positon, there is risk to you if the price of the underlying goes down after you have entered a synthetic long stock position.

If the underlying price goes to zero and the option cycle expires, you would lose all the money you paid to enter the position.

You will lose when the underlying price is lower than the strike price of the short put option.

**How to calculate the potential loss
of a synthetic long stock position is shown below:**

- If the position is entered as a debit:

Potential Loss = Strike price of the short put option minus the price of the underlying plus the net premium you paid plus commissions.

**For Example:**

105 (strike price) – 100 (underlying price) + $3 (debit) + $1 (commissions)

= $8 (loss)

- If the position is entered as a credit:

Potential Loss= Strike price of the short put option minus the price of the underlying minus the net credit paid plus commissions

**For Example:**

$105 (strike price) – 100 (underlying price) – $3 (credit) +1 (commissions)

= $3 (loss)

**What are the breakeven
points for a synthetic Long Stock Position?**

- If the position was entered as a debit:

Breakeven Point = Strike price of the long call option plus the net premium paid to enter the position plus commissions.

**For Example:**

$105 (strike price) +$2 (debit) +1 (commissions) = 103 (breakeven)

- If the position was entered as a credit:

Breakeven Point = Strike price of the long call option minus the net credit received to enter the position plus commissions.

**For Example:**

$105 (strike price) – $3 (credit) +$1 commissions) = $103 (breakeven)

**Synthetic split-strike positions can
also be created…**

Synthetic long stock and synthetic short stock positions use at-the- money strike calls along with the same expiration at-the-money strike puts.

Synthetic split-strike positions can also be constructed and are discussed a little bit in this article:

**Are Synthetics the same as owning
stock?**

One of the key differences between buying stock outright and creating a synthetic stock position is: an option has an expiration date of which you must be aware. It will expire. Stock does not have an expiration date.

If you own stock that pays dividends, you receive those dividends. If you create a synthetic position, you will not receive dividends. Options do not pay dividends.

In the United States, stock which you hold for a certain period of time may have tax advantages. A synthetic option position does not receive those same tax advantages.

**Simulate buying or selling indexes
using a synthetic long stock position.**

Indexes such as RUT and SPX do not allow you to purchase the underlying outright.

You can create a synthetic position using options, which would be identical to buying or selling the underlying.

If you want to create a long position to simulate buying the index, you would buy an at-the-money call option and sell the at-the-money put option using the same strike price and same expiration.

If you want to create a short position which would simulate selling the index, you would buy the at-the-money put option and sell the at-the-money call option using the same strike price and same expiration.

**Key Takeaways**

- The synthetic long stock strategy is a bullish position.
- To create the position, purchase a call option and sell a put option at the same strike price in the same expiration cycle.
- The synthetic long stock strategy replicates buying 100 shares of stock.
- Maximum profit is unlimited.
- Maximum loss occurs if the stock goes to zero.
- One advantage to the synthetic long stock strategy is the margin requirements could be less than purchasing 100 shares of stock.
- An option has an expiration date of which you must be aware. It will expire. Stock does not have an expiration date.

If you have found a particular synthetic long stock position to be helpful or a hindrance in your trading please comment below. We can benefit from each other’s experiences good or not so good.

]]>1. Selling a Covered Call

2. Selling a Naked Put

Most people would say selling a Covered Call is a great investment strategy, but selling a Naked Put is terribly risky. If you understand Option Synthetics, you'll know that these two positions are **exactly** the same!

- Selling a Covered Call
- Selling a Naked Put

Most people would say selling a Covered Call is a great investment strategy, but selling a Naked Put is terribly risky. If you understand Option Synthetics, you'll know that these two positions are **exactly** the same!

It is because of the mathematical relationship between Calls and Puts. You can use either Calls or Puts to construct identical positions. To understand how this is possible, you have to understand that mathematical relationship first and what option synthetics are.

According to the Merriam Webster online dictionary, the definitions of “synthetic” include:

– produced artificially

– devised, arranged, or fabricated for special situations to imitate or replace usual realities

This is exactly what option synthetics are: **artificial or fabricated positions**. They imitate or replace another position. To understand how option synthetics work, we have to examine the basic relationship between puts and calls. It is a strict mathematical relationship:

K + C = U + P + I + D

Where

K = Strike Price

C = Call

U = Underlying stock price

P = Put

I = Interest

D = Dividends

Normally, the effects of interest and dividends are small and can be ignored. There are situations where interest and dividends affect this equation:

– If you are trading in times with higher interest rates (remember when the prime rate was 20% in 1980?)

– Trading with longer time frames (such as LEAP options)

– Investing in dividend producing stocks

In these situations, you can't ignore Interest and Dividends. For our shorter term trading with very low interest rates, we will take Interest and Dividends out of the equation. This leaves:

K + C = U + P

Because the strike price is a constant value, let's remove it from the equation to simplify the examination the call, put and underlying price relationship:

C = U + P

In this equation, positive values (+) are long and negative values (-) are short. This means:

+C = Long Call

-C = Short Call

+P = Long Put

-P = Short Put

+U = Long Stock

-U = Short Stock

This simplified equation let's you derive the six basic synthetics relationships very quickly. If you remember from basic algebra, moving a variable from one side of the equation to the other side, changes its sign. My 8th grade teacher called it “jumping the fence”). Let's see what that looks like:

Long Call | = | Long Stock + Long Put | +C | = | +U + P |

Short Call | = | Short Stock + Short Put | -C | = | -U – P |

Long Put | = | Long Call + Short Stock | +P | = | +C – U |

Short Put | = | Short Call + Long Stock | -P | = | -C + U |

Long Stock | = | Long Call + Short Put | +U | = | C – P |

Short Stock | = | Short Call + Long Put | -U | = | -C + P |

If we reference the table above, we can see that a Short Put = Short Call + Long Stock. Let's compare

- Long Stock
- Long Stock + Short Call (Covered Call)
- Short Put (Synthetic Long Stock + Short Call)

NOTE: The differences between the Greeks for the Covered Call and Short Put are due to OptionVue's rounding of the option mid-prices to the nearest $0.05

We see the margin for the Long Stock is the highest, then the Covered Call (using 50% margin) then the Short Put. The temptation is to use the same amount of capital selling short puts that you would have spent on the Long Stock or Covered Call. You could sell five short puts for nearly the same amount as buying 100 shares of stock. You would be very highly leveraged if you did that. Your profits and losses would be magnified by five times! Avoid that temptation!

A collar is Long Stock and sell a Call and purchase a protective put. Using our algebraic notation the position is:

U + P – C

If we group them like this:

[U + P] – C

We can use the synthetic equivalent of Long Stock + Long Put, which is a Long Call:

[+C] – C

We have a Short Call and a Synthetic Long Call. These are at two different strikes so we have a vertical spread:

For example, on Dec 8, 2011, Goldmann Sachs (GS) was trading at $100.03 during the day. The option prices for the options with 9-days until expiration were:

105 Calls = $1.60

105 Puts = $6.60

95 Calls = $6.60

95 Puts = $1.60

If we own the stock we can sell the 105 calls for $1.60 and purchase the 95 puts for $1.60 for a net $0.00. This “collars” our stock. We have limited our upside profit potential but reduced the maximum loss on the trade.

If we sell the same 105 Calls for $1.60 and purchase the 95 Calls for $6.60, we have a net debit of $5.00.

If we sell the 105 Puts for $6.60 and buy the 95 Puts for $1.60, we have a net credit of $5.00

All of the positions have the exact same risk! Notice the margin for the call or put vertical spreads are both $500 vs the stock margin of $5000 (with 50% margin). The temptation exists for buying 10 verticals, but this has 10 times the profit and 10 times the potential loss!

There's little reason to collar a stock unless you want to hold the stock for dividends. The short call could be a problem if the stock rallies and you want to keep the stock. You would have to buy back the short call at a loss before the short option was assigned to you. If you are considering collaring a stock, also consider selling the stock and putting an option-only vertical spread on instead.

Suppose you own Long Stock and the company is going to report earnings but you're going on vacation. How can you hedge your position without selling your stock? You can short the stock synthetically with options!

Short Stock = Short Call + Long Put

If you pick the same strike for your short call and long put, you have a synthetic short stock position. If you split the strikes, you have a flat risk chart in between the two strikes. Because you own the Long Stock, you are creating a collar (see Case 2 above).

For example, if your stock is at $100 per share and the you sell a 105 Call and buy a 105 Put, you have zero risk (and zero profit potential). Your risk chart is a flat line. Here's what it looks like:

There are many uses of synthetic options and it is very useful to know the relationships of C = U + P. It's easy to quickly figure out what the synthetic equivalent is by putting one variable on one side of the equation.

Have you used option synthetics? Do you have any questions about them? Leave your comments below or post them in our online discussion forums.

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