One of our readers asked me about synthetic positions and since they are so important I thought I'd do a post on them. A synthetic position enables a trader to have the same risk reward as another position.
Lets go over a one that is a pet peeve of mine. The buy-write vs the synthetic buy-write. The buy-write is probably the most common spread people use options for. The trader will be long 100 shares of stock and short 1 call. The upside is limited to the strike price of the short call while the downside is to zero. Here is a chart of the risk reward of a buy write in Citigroup (C), selling the June 4.5 call at $0.31:
So if you put this trade on at the close today you would be long C at $4.54 and short 1 June 4.5 call at $0.31 for net debit of $4.23 ($4.54-$0.31) excluding commissions. The max gain on this trade is $0.27 ($4.5-$4.23) excluding commission's. The max loss is if the stock goes to zero. Now lets look at the risk reward of the synthetic buy-write.
As you can see in the chart above its exactly the same! And we did this buy shorting 1 June 4.5 put. You could have sold the put for $0.26 today at the close so you would make $0.01 less but you wouldn't have the commissions from the stock plus you would have more capital to trade with since you wouldn't be long the stock. Synthetics are important because sometimes you can get better pricing synthetically than if you just did the trade regularly so always check! Also during times you can't short a stock because its hard to borrow always remember you can synthetically short the stock.
So why is the synthetic buy-write my pet peeve? Well I hate that some brokers, traders, pundits, etc don't recognize that a short put is the exact same thing as a buy write. I can't stand it when I hear about how "safe" buy-writes are suppose to be then the next second hear about how risky shorting puts are..... its the same thing!
So what are the other synthetic positions you can make with options?
synthetic long call = long stock, long put
synthetic short call = short stock, short put
synthetic long put = short stock, long call
synthetic short put = long stock, short call
synthetic short stock = short call, long put (same strikes)
synthetic long stock = long call, short put (same strikes)
There are obviously more combinations as you do more advanced and complex spreads and strategies but we'll leave it at that for now. Have a great weekend! Please ask any questions if you have them.
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