Synthetic Options
One of the most powerful tools an option trader can have is to understand synthetic options. Synthetic options are not a specific type of option such as a call or put. Instead, they provide a method of combining stock, calls, and puts in such ways so that they behave like another asset. For example, if we combine long stock with a long put, those two positions together will behave like a long call option from a profit and loss standpoint. We would then say that long stock combined with a long put is a synthetic call option.
Understanding synthetic options will benefit you in many ways. First, you will gain insights into option pricing theory. At first thought you may wonder, "Who cares about theory?" After all, the only things that matter in the real world are the actual prices -- not what the prices ought to be. However, there are times when theory answers questions that otherwise would not be known. For example, perhaps you will buy an at-the-money put and selling an at-the-money call in the next month. Will you need to set aside a sizable amount of money to pay for it? No. Since an at-the-money call is always more expensive than an at-the-money put, that trade will always result in a net credit. This can be shown by synthetic pricing relationships. You will understand how options are created and why the market makers are quoting options the way they are.
A second benefit of synthetics is that you can locate trades that result in a statistical advantage to you. Synthetics will also help you to hedge positions masterfully rather than using the roundabout, inefficient methods often used by many new traders.
A third advantage is that it will allow you to effectively do things many traders will tell you cannot be done such as shorting stock on a downtick (or even when no stock is available), buying calls or selling naked puts in an IRA, buying stock for virtually no money down and a host of other imaginative strategies.
If you wish to master options trading, understanding synthetic equivalent positions is essential.
What Is A Synthetic Equivalent Position?
The name sure sounds intimidating, but synthetic options are actually fairly easy to comprehend and are truly a fascinating and useful part of options trading. In order to understand these mysterious sounding assets, you need to understand one of the most fundamental concepts of option pricing known as put-call parity.
Put-Call Parity
Parity is just a fancy word for equivalence. There are many "parity" relationships in finance and they all show some type of mathematical tie between one asset and another asset or group of assets. Put-call parity is a relationship showing that put and call prices are very dependent on one another as well as the price of the underlying stock and interest rates. The prices of puts and calls are not just arbitrarily chosen by market makers, contrary to what many people believe. In order to understand the put-call parity equation better, it's best to show how orders are filled on the floor of an exchange. Here's an example of how it works with a simple hypothetical trade:
| Trade: Buy to open 10 ABC $50 calls (one year to expiration) at market. ABC stock is also trading at $50. |
When this buy order is received on the floor, the market maker must become the seller so that the transaction can be completed. This means the market maker must be willing to sell or short a call. Now, while you may be totally comfortable in speculating by buying 10 calls, the market maker may not be so eager to be on the short side. The reason is this: market makers are in the business to take 1/8 or 1/4 of a point on a large number of trades; they are not really too interested in holding open speculative positions over long periods of time -- especially short calls that have unlimited upside risk! Market makers prefer to fully hedge themselves for guaranteed small profits but do so over a large number of trades.
How does the market maker create a short call?
If the market maker is to be short a one-year call, his risk will be that the stock moves higher. So in order to protect himself from this risk, he will purchase 1,000 shares (since 10 contracts control 1,000 shares) for $50,000. Now, no matter how high the stock moves, he will always be able to deliver 1,000 shares of stock at expiration. By purchasing the stock, all of the upside risk has been removed.
However, now there is a new risk in that the stock may fall. So to protect himself from this, he will buy 10 $50 puts with one year to expiration. We're going to assume he pays $5 per put, although it doesn't really matter what the price is. As we will soon see, the price he pays for the put will be reflected in the price he charges you for the call, just as any business will price their products above costs. Purchasing the stock and put option are part of the market makers cost in creating a long call for you. By purchasing this $50 put, all of the downside risk has now been removed.
So our market maker is now long 1,000 shares of stock and long 10 $50 put options, which puts him in a no-risk situation of being short a call. He can now fill your order for 10 long calls, but what price should he charge? Please keep in mind as we move forward that the market maker is now long the stock, long the $50 puts, and short the $50 calls. You are long the $50 calls.
In order to understand how the market maker will price your call options, it's necessary to understand that the three trades he places -- long stock, long put, and short calls -- provides a perfect hedge. A perfect hedge means that all risk has been removed from the position and he does not care one way or another whether the stock sits flat, runs to the moon, sinks to the ground, or settles at any price in between. There is no risk to the market maker! How can that be?
Well, the stock price can do one of three things between now and expiration of the call option one year from now. It can stay the same, go up, or go down. If the stock stays exactly at $50, the $50 call and $50 put expire worthless and the market maker's position is worth exactly $50,000, which is the amount he originally paid for the stock. If the stock closes above $50, the long put will expire worthless and the market maker will get assigned on the short call and lose the stock; however, he will be paid the $50 strike and receive exactly $50,000. Likewise, if the stock closes below $50 at expiration, the short call will expire worthless and the market maker will exercise his put and receive $50,000. These actions are summarized in the following box:
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If stock is at $50: If the stock is above $50: If the stock is below $50: Note that no matter what happens to the stock price, the market maker's position is guaranteed to be worth $50,000 in one year. |
At Expiration:So with the long stock at $50, long $50 put and short $50 call, the market maker is now guaranteed to receive $50,000 in one year. It is kind of ironic that by using these speculative derivatives of puts and calls we can actually create a risk-free portfolio.
Now, if any financial asset is guaranteed to be worth a certain amount in the future, then its value today must be worth the present value discounted at the risk-free rate of interest.
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Similarly, if someone owes you $105 one year from now and interest rates are 5%, then you should be willing to accept $105/(1+5%) = $100 today. In other words, it should make no difference to you whether you wait one year and receive $105 or collect $100 today. That's because you can take the $100 today, invest it at 5% for one year, and still have $105 a year from now. So the present value of $105 one year from now is $100 (if rates are 5%). To calculate the present value, we simply take the future value of the asset and divide it by 1 + risk-free interest rate. |
In other words, this position acts just like a zero-coupon bond (in fact, as we
We just showed that the market maker is guaranteed to receive $50,000 in one year regardless of the stock price. What is this position worth? If it's guaranteed to be worth $50,000 in one year, then the value today must be the present value, which is $50,000 / (1.05) = $47,619. This means the market maker should pay $47,619 today for the three positions. If he pays $47,619 and receives $50,000 in one year, his return on investment will be 5%, which is exactly the interest rate he should receive for a risk-free investment. We can check this by taking $47,619 * 1.05 = $50,000.[1]
The market maker will spend $50,000 for the 1,000 shares of stock trading at $50. He also paid an additional $5,000 for the put for a total cash outlay of $55,000. We already figured that the fair price for this package of long stock, long put and short calls should be worth $47,619 yet he's already laid out $55,000 for it. He will need to offset this high price from the sale of the calls he's selling to you.
The market maker therefore needs a credit of $55,000 - $47,619 = $7,381. He will need to bring in a credit for this amount, so he will fill your order on the 10 $50 calls for roughly $7.38. Doing so, he will receive the necessary credit to make his $55,000 cash outlay equal to $47,619. Of course, the market maker will try to make a 1/8- or 1/4-point profit so your order would probably be filled around $7.50.
To summarize, the market maker's initial position looks like this:
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Buy 1000 shares at $50 = -$50,000 Buy 10 $50 puts at $5 = -$ 5,000 Sells 10 $50 calls at $7 3/8 = +$7,381 Equals -$47,619 cash outlay by market maker |
This three-sided position (long stock + long put + short call) established by the market maker is called a conversion. If he had done the reverse (i.e. short stock + short puts + long calls) then it is called a reversal or reverse conversion.
It is imperative to understand conversions and reversals since they are the building blocks of synthetic equivalent trades.
The Put-Call Parity Equation
We have shown that the market maker's three-sided position (conversion) is guaranteed to be worth the exercise price of $50 at expiration. Because he's guaranteed this strike price, the conversion must be worth the present value of the exercise price. We can rewrite this using S for stock price, P for put price, C for call price, and E for exercise price as follows:
Equation 1.1, The Put-Call Parity Equation:
S + P - C = Present Value E
And in this little equation lies the magic behind synthetic options!
Equation 1.1 is known as put-call parity. If you know the value of any three of the four values (stock, put, call, present value of exercise price) you can immediately figure out the value of fourth.
Notice the notation with the plus and minus signs. Starting at the left, the S has no sign so is assumed to be positive. Next, the long put position is denoted by a "+" sign and the short call is denoted by "-". This is telling us that a long stock position plus a long put plus a short call must equal the present value of the exercise price. This notation of plus and minus signs to represent long and short positions will be important to remember later.
To make things a little easier to understand, we know the present value of E (the right side of the equation) is guaranteed to grow to E so it behaves like a risk-free investment such as a T-bill (or Treasury bill, Treasury note or Treasury bond). We can therefore rewrite the above equation as:
Equation 1.2
S + P - C = T-bill
With some very basic algebra, we can create many interesting positions, which you've probably guessed will be called synthetic positions.
One Small Adjustment
Before we can continue with some examples, there is one small adjustment we need to make to the formula and is best shown with an example. Let's say we are interested in seeing what a long stock + long put position are equal to. The trick to using the equation is to isolate the asset or assets on one side of the equation with the correct sign.
In this example, we need to get the stock and the put on one side of the equation so that both have plus signs. By looking at equation 1.2, we can see that the long stock and long put are already together on the left hand side. In order to isolate them, we need to move the short call to the right hand side by adding C to both sides. Once we do, we have a new equation:
S + P = C + T-bill
What does this mean? It means that someone holding long stock and a long put in a portfolio (the left side of the equation) will have exactly the same portfolio balance at option expiration as another person holding a long call plus a T-bill (the right side of the equation).
Let's see if it holds true:
Assume we are interested in one-year $50 options and interest rates are 5%:
Investor A holds stock at $50 and a $50 put (left side of the equation).
Investor B holds a $50 call and a T-bill (right side of equation).
Investor B will pay $50,000/(1.05) = $47,619 for the T-bill.
At expiration:
| | Investor A | Investor B | ||||
| Stock price | Stock | $50 put | Total value at expiration | T-bill | $50 call | Total value at expiration |
| 35 | 35 | 15 | 50 | 50 | 0 | 50 |
| 40 | 40 | 10 | 50 | 50 | 0 | 50 |
| 45 | 45 | 5 | 50 | 50 | 0 | 50 |
| 50 | 50 | 0 | 50 | 50 | 0 | 50 |
| 55 | 55 | 0 | 55 | 50 | 5 | 55 |
| 60 | 60 | 0 | 60 | 50 | 10 | 60 |
| 65 | 65 | 0 | 65 | 50 | 15 | 65 |
| 70 | 70 | 0 | 70 | 50 | 20 | 70 |
| 75 | 75 | 0 | 75 | 50 | 25 | 75 |
| 80 | 80 | 0 | 80 | 50 | 30 | 80 |
| 85 | 85 | 0 | 85 | 50 | 35 | 85 |
Regardless of where the stock closes, investor A will be worth exactly the same as investor B. There are no differences in the two portfolios as shown by the "total value at expiration" columns for each investor -- they are exactly the same. Why does this happen? Portfolio A can never fall below $50, which is the strike of the put. However, if the stock rises, investor A will participate fully in the rally. Portfolio B, on the other hand, must grow to a value of $50 because that is the T-bill portion and is guaranteed. Portfolio B, like A, can therefore never have a value below $50. If the stock rises, investor B's call will start to increase in value by the same amount as the increase in stock in A's portfolio, so both A and B receive all of the upside potential in the stock.
Portfolio B is said to be the synthetic equivalent of portfolio A. Likewise, A can be said to be the synthetic equivalent of B.
So a synthetic equivalent -- or synthetic -- is any position that has exactly the same profit and loss, at expiration, as another position using different instruments.
Now here's the one small adjustment I was referring to at the beginning of this section. By definition, synthetic positions only track the changes in portfolio values and not the total values. For example, in the above example with investors A and B, the total value of B's portfolio is the same as A's. To have the synthetic equivalent, we only need to track the changes. If B just held the $50 call option and not the T-bill, he would exactly reflect the changes in A's portfolio.
For example, if A buys the stock for $50 and it falls to $40, A can exercise the put and receive $50 -- so A starts with a value of $50 and ends with $50 and therefore has no change. Portfolio B would also reflect no change as well since the call would expire worthless. If the stock is trading at $60 at expiration, portfolio A will be worth $60 reflecting a change of $10 from the beginning $50 value. Portfolio B will also change by $10, as the $50 call will now be worth $10.
The whole point of all this is that, with the original equation S + P - C = T-bill, we can ignore the T-bill on the right hand side as it helps to account for total value but not for the changes in portfolio value.
Now our equation is even easier. All you need to know is:
Equation 1.3
S + P - C = ?
Using this equation, we can figure out any synthetic position. Notice that there are only three assets in the equation: stock, puts, and calls. Before we get into the details of figuring out synthetic positions, it is important to understand a very simple property. That is, the synthetic equivalent of any one asset will be some combination of the other two. In other words, stock can be formed by some combination of puts and calls. Calls can be replicated by some combination of stock and puts.
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Another way of looking at it is this: the synthetic equivalent will never include the asset you're trying to replicate. For example, a synthetic long call will not include a call option in the answer. If you come up with that, a mistake has been made. The only thing left now is to figure out whether those combinations are long or short.
We will take it slow with lots of examples, so hang in there!
Synthetic Positions
Now that you have equation 1.3, let's work through some examples to see how to figure out -- and understand -- synthetic options.
Let's start with a synthetic long call. Remember, the answer we come up with should be a combination of assets that behaves just like a long call option at expiration, and it will be some combination of stock and puts.
Synthetic long call
To find out the specific combination of assets that behave like a long call, all we need to do is reference equation 1.3:
S + P - C = ?
and it will be easy. To start, we need to get the asset that we're trying to replicate (either the stock, put, or call) by itself and with the correct sign. Since we are trying to find out the synthetic value of a long call, we need to get a +C (remember, we are using "+" to denote a long position) on one side of the equation. Using some basic algebra, if we add C to both sides of the equation we get S + P = C, and there's the answer; long stock plus long put (left side of the equation) will behave just like a long call (right side of equation). Therefore, if you hold long stock and a long put, you have a synthetic call position.
Let's check the profit and loss diagrams to see if we're correct:
We can easily see there is no difference between long stock + long $50 put purchased at $5 (left chart) and long $50 call purchased at $5. The person holding the long stock and long put raised the cost basis of their stock from $50 to $55, that's why their breakeven point is now $55, which is the point where the profit and loss line crosses the $0 profit and loss mark. However, they still participate in all of the upside movement of the stock. What if the stock falls? The investor is protected for all prices below $50, which is the strike of the put. The worst that can happen is for the stock to fall to zero. This investor will exercise the put and receive $50 effectively only losing on the $5 he paid for the put; therefore the maximum loss is $5.
For the call holder (right chart), he paid $5 so his maximum loss is also $5 but he also participates in all the upside of the stock. The stock will have to be $55 at expiration in order for the call holder to break even since he has the right to buy stock at $50 but paid $5 for that right. This effectively makes his breakeven price $55 as well.
It should now be apparent that call owners get downside protection as well as put holders; the call keeps you from losing value in the stock because you are not holding the stock.
We can use this information to gain some trading advantages. For example, most firms do not allow investors to buy call options in their IRA (Individual Retirement Account) but now you know that it can be done in a roundabout way with synthetics. You simply buy the stock and put, so you are effectively long a call option. Now, your return on investment will be much lower using long stock plus a long put as compared to the person who buys only the call. This is due to the difference in capital required to purchase the stock, but the two positions will behave the same in terms of net gains or losses at expiration.
Examples
1) A stock is trading at $60 and you wish to own a $50 call in your IRA. You find that your brokerage firm does not allow long calls in IRAs. How do you effectively buy a $50 call?
Answer: Buy the stock and buy the $50 put.
2) We just saw that a long call is synthetically equal to long stock plus a long put. What do you suppose is the equivalent of a short call?
Answer:
A short call is the opposite of a long call. Therefore, a short call is synthetically equal to short stock plus a short put. Just change the signs and you have the opposite position!
Synthetic long stock
Can we use equation 1.3 to see if there's a way to own stock synthetically? Without looking ahead, see if you can use the equation S + P - C = ? and solve it for long stock. Hint: just get S by itself with a positive sign and move the put and call to the other side taking note of their sign change.
Because we have +S on the left side already, let's move the C and P to the other side. To do this we need to add C and subtract P from both sides. If you did it correctly you should find that S = C - P. Now you know that a trader holding a long call and short put (right side of equation) is actually holding synthetic stock (left side).
Looking at the profit and loss diagrams for each:
We see there is no difference between the two positions. The long stock purchased at $50 (left chart) will gain and lose point-for-point to the upside as well as the downside. The same holds true for the long $50 call and short $50 put (right chart). The $50 call will gain point-for-point at expiration while the short put will become a liability (loss) point-for-point if the stock should fall.
So synthetic stock is just a long call plus a short put. What would synthetic short stock be? Once again, all we have to do is change the signs of our previous answer and find out that a long put plus a short call will behave just like a short stock position. This is great to know for all traders involved in short selling. Now you know how it is possible to short stock without an uptick or when stock is not even available for shorting -- use synthetics!.
| Question |
How much will it cost to short synthetic stock? As we said at the beginning of this report, the synthetic equation will lend insights into option pricing and we can certainly use it to answer this question. The answer is that you should receive a credit. This can be shown by the original equation S + P - C = Present value of E. If we rearrange so that C - P = S - Present value E, we see that if S and E are equal (in other words, at-the-money), then S - Present value E must be a positive number. In order for C - P to be positive, C must be more expensive than P. Because you are buying puts and shorting calls, you should get a slight credit to enter a short stock position.
Realistically though, because of bid-ask spreads and commissions, it may cost you a slight debit. Regardless, it will not be a major cash outlay to enter this position (please keep in mind that there will be significant margin requirements to do so). However, they should not exceed (and will usually be much less) than the Reg T requirement of 50% required to short a stock. So not only can synthetics allow trades that otherwise cannot be done, they usually allow it to be done in a more efficient way by requiring less capital to take the same position.
Example
Recently, between May 17 (shown by the dotted vertical line) and June 3, 2002, the OEX took yet another plunge as shown in the following chart. While there is usually no way to short the OEX index, you could have done it synthetically. On May 17, the index was trading at 550 and the 550 calls were $13.00 with the 550 puts at $11.80. As we showed earlier, an at-the-money synthetic short will usually result in a slight credit, which was the case here. Selling 20 calls and buying 20 puts would result in a net credit of 20 contracts * 100 * $1.20 credit = $2,400. Just 17 days later, at the close of trading, the puts were worth $38.20 and the calls 0.80. The synthetic short position could have been closed out for a credit of $37.40 * 20 * 100 = $74,800.
For no money down (in fact, a credit of $2,400) you could capture a $70,000 profit in just no time. Of course, this trade does not come without risk. The risk is that the index traded higher, which would have left you in for a loss. Regardless, synthetics allow you to initiate positions that others will tell you cannot be done. The more agile and efficient you are at establishing positions, the better trader you will become. Synthetics give you those abilities.
| We just showed that an at-the-money call must be more expensive than an at-the-money put. Is there a relationship as to how much money will separate the two prices? |
More About the Synthetic Long Position
We just saw that purchasing a call and selling a put can create a synthetic long stock position. In fact, we also showed that an at-the-money call will be priced higher than an at-the-money put. An interesting question is how much higher will it be priced?
We can answer this using equation 1.1. With that, we can rearrange it and show:
S - Present Value E = C -- P. If the options are at-the-money, then S must be equal to E by definition. We can then rewrite the equation as S - Present Value S = C -- P. The equation then says that the stock price minus the present value of the stock price must be the same (is equal to) as the difference between the call and put. What is the difference between S and the present value of S? It is simply the cost of carry. This means that a long call and a short put not only behaves like a long stock position but, more specifically, a long futures position. Remember that the futures contract will be priced to include the cost of carry, just as the synthetic long position.
This is probably the most important piece of information in this course if you are trading futures. Because the long call + short put position is a long futures position, we can then use options to effectively create futures and we will need this information to understand the next course. Make sure you understand how to create long and short stock (futures) positions with options!
Synthetic Covered Call
What is a synthetic covered call? We know a covered call is long stock plus a short call, so it would be represented by S - C in our equation. Looking at the equation S + P - C = ?, we need to get S and -C on one side. In order to do that, we can just subtract P from both sides and get S - C = -P. A covered call position is therefore synthetically equivalent to a short put.
As expected, the profit and loss diagrams are the same. For the covered call position (left chart), the investor buys stock at $50 and sells a $50 call for $5 effectively giving the stock a cost basis of $45, which is shown to be the breakeven point. If the stock rallies above $50 at expiration, the investor will be forced to sell it for $50 regardless of how high the stock moves. The investor cannot profit above a stock price of $50, which is why the profit and loss line flattens out at $50 and higher.
The short put (right chart) is at risk for all stock prices below $50 which is offset by the $5 premium received which gives a breakeven point of $45. The short put seller keeps the $5 premium for any stock price above $50, which is why the profit and loss line flattens out above $50. However, if the stock falls below $50, the short put seller starts to head into losses -- just like the covered call writer.
Example
You wish to sell a naked put in your IRA but your broker says it's against policy to do that. How can you do it synthetically?
Answer: You one can buy stock and sell calls, which is exactly the same thing from a profit and loss standpoint. So while your broker will probably not allow naked puts (unless cash secured), you can always use covered calls.
Understanding synthetics also allows investors to gain insights about the risks of their own trades. How many times have you heard that covered calls are "conservative" and that naked puts are "high risk"? Once you understand synthetics, you'll know there is no difference between the two. It is ironic that most brokerage firms require level 3 option approval to short puts yet require only level 0 to enter covered call positions. If you wouldn't short a put on a particular stock, you shouldn't enter into the covered call either.
Added Insights Into Synthetics
We said earlier that the market maker using a conversion was perfectly hedged against all risk. Now that you understand synthetics, it will be easier to see why. Recall that the conversion was:
S + P -- C = Present Value E
We can see in the formula that the market maker is long stock, which is denoted by the positive S. What position do you suppose would offset a long stock position? Hopefully you guess it would be a short stock position. If you are long stock and are also short the same stock you have no risk. Now look back at the equation and, aside from the S, we see the market maker also has a long put and a short call -- a synthetic short stock position. Effectively then, the market maker is long stock and short stock, so he has eliminated all risk. Remember though, that he did this for a profit!
We could also look at the equation and say that the market maker is long a put option, which is denoted by the +P. You should now understand that a short put will exactly offset a long put and eliminate all risk. The remaining +S and --C are exactly a short put.
It turns out that no matter which asset you pick, the other two are the synthetic opposite and fully hedge the risk. We could also pick any two assets and know that the third will fully hedge those two.
We can use synthetics to better understand why multiple trades such as buy-writes are valuable. A buy-write is simply a covered call but is executed simultaneously. For instance, rather than buying the stock and then selling the call as a separate order, you can instruct your broker to enter a buy-write; you'd buy the stock and simultaneously sell the call. What's the difference? The difference is that the market maker receives two of the necessary three positions to fully hedge himself so can offer you a better price! Use multiple order entries whenever possible.
All Combinations of Synthetics
It is great practice to run through equation 1.3 and figure out the various combinations of synthetic trades. If you are really motivated, try to draw the corresponding profit and loss diagrams. All of the combinations are listed below for your reference.
Long stock = long call + short put
Short stock = short call + long put
Long call = long stock + long put
Short call = short stock + short put
Long put = short stock + long call
Short put = long stock + short call
How Do Market Makers Arrive At Their Option Quotes?
Market makers must balance the demand for calls and puts by raising and lowering prices. However, they cannot just arbitrarily raise stock, call or put prices as they are all tied together by the put-call parity relationship. At the beginning of this report, we showed that a one-year $50 call option would theoretically be worth about $7.38 if the stock were $50, the $50 put was $5, and interest rates were 5%. In that scenario, we would say the "fair value" of the call option is $7.38. The market maker, however, will try to make a profit whether he's buying or selling. He may, using this example, post an asking price of $7.50 for the call (the price he's willing to sell) and a bid of $7.25 (the price he's willing to pay). Likewise, we saw that the market maker could accomplish this conversion by paying $5 for the put. Therefore, he may bid $5 for the put and ask $5.25. No matter which trade comes across his desk, he can fully hedge it for a profit. Market makers just "straddle" the fair values of calls and puts and bid low and offer high.
Finding Optimal Trades
Synthetic pricing relationships can also allow you to become more efficient because they allow you to understand various equivalent trades and to pick the best one for your situation.
A quick insight gained from synthetics is that the market makers will bid below the fair value and offer above fair value. Therefore, if you continually buy at the asking price and sell at the bid, you are significantly stacking the odds against you. Trading "in between" the bid and ask can greatly improve your results. Please don't confuse this to mean that you should never buy at the ask or sell at the bid. There are certainly times when it makes sense to do so. The important point is to understand that you have a mathematical disadvantage by doing so. This is because the market makers will tack on a profit to the fair value of the option. Once you pay above (or sell below) the fair value, you are statistically disadvantaged.
Let's look at another use. Assume you wish to buy a call option. Are you better off buying the call or taking the synthetic equivalent and buying the stock and buying the same strike put? Check the quotes for each trade and you will see that there is often a slight difference, which makes one better than the other -- especially if it is a large trade. For example, most beginning investors tend to stick with covered calls. But this trade entails two commissions and two bid-ask spreads that both work against the investor, since he buys the stock at the ask and sells the call at the bid. Most market professionals, however, tend to use naked puts since there is only one commission and one bid-ask spread. The risk profile is the same in either case, but the naked puts are a more efficient way of doing it.
Synthetic trades may seem complex at first, but they are actually quite simple. Many think they are a needless academic exercise and of no practical use. Nothing could be further from the truth. If you plan to actively trade options, it is crucial to understand synthetics. Market makers make their living with the put-call parity relationship, so don't think it's a waste of your time to gain a basic understanding. A little time spent learning will make option investing worth your time.
[1]This doesn't work out to exactly $50,000 because we rounded the present value down to $47,619. The true present value is slightly less than $47,619.05.
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