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Synthetic Stock Options Trading Strategy

Filed Under Advanced Options Trading 

Synthetic Stocks
 
Personally, I prefer the name “shadow stock”; it sounds so much more romantic and mysterious compared to the rather sterile name of “synthetic stock”. I smacks of something you’d buy at Wal-Mart. But, undaunted, we press forward to discuss an important aspect of the many facets of stock options.
 
Creating a synthetic stock position-either long or short-has some distinct advantages when trading stocks. They’re cheaper, more flexible and have limited risk as opposed to the theoretical “unlimited risk” of actually owning the stock. Yes, an option has a limited life but we are talking a trading strategy and not a buy and hold scenario.
 
The first synthetic position we’ll talk about is creating the long synthetic stock. The major objective of establishing a synthetic position is to construct a position that will closely mimic the movements of the underlying stock.
 
Construction of synthetic long stock
 
In order to create a synthetic long stock position, you want to buy a call and sell the corresponding put in a one-to-one ratio. But how can an option position be just like a stock when you’re buying a call and a put?
 
What happens is that both option positions are identical because they are corresponding options, which means that both positions have the exact same Greeks, or in other words, the same risk factors and profit potential of the real long stock position; the synthetic long as created by the corresponding options will exactly mimic the real long position in all ways.
 
In the Options Mastery course offered by the Options University, they give an example of what you are looking for. Suppose you want to set up a synthetic long position for a stock currently trading at $65.50. First thing, you decide that you will hold the position for about three months, a time you estimate sufficient for the stock to do what we think will happen. Let’s say you pick a June option period. You look at the June $65 strike. You see that the call has 56 long Deltas.
 
However, you now need to sell a put at the same strike and month and you see that this put option will short 44 negative Deltas. If you sell the put, you will be short, which is also a negative and the two negatives of the put and the short sale equals a positive. At this point we are long 56 Deltas from the call and also long the 44 Deltas from the put. This means that the position made up of the corresponding call and put has 100 long Deltas; 100 Deltas means that the position is exactly correlated with the long stock position. This is no coincidence, you see, corresponding options will always sum to an absolute value of 100 Deltas. The relative value depends on whether the position is short or long.
 
Here’s the kicker, corresponding options also have the same Gamma, Vega and Theta but a real stock position only has 1.0 Delta for each stock. However, the long call and short put Gamma, Vega and Thetas cancel each other out; so, in effect, both the option positions now have only 100 Deltas (100 share contract) as will the 100 shares of underlying stock; therefore, they are both the exactly the same. When this happens, the option positions will match the underlying stock movement penny for penny.
 
Of course, to assume a synthetic position will cost a fraction of what buying the stocks would cost. This allows you to either “buy more stock” or diversify your capital into other investments. The only difference is time.
 

For more information on everything to do with stock options, go to: www.optionsuniversity.com

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