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Advanced Options Trading - Understanding Synthetics: the Basic Formula

Filed Under Advanced Options Trading 

Understanding Synthetics: the Basic Formula
 
Let’s talk about put/call parity. Say What? You remember that’s the fact that a corresponding call and put are equal to the parity of the stock at that strike price. In other words, a corresponding call/put will be mathematically related to the current value of the underlying stock. This is key to understanding the option strategy of stock replacement.
 
In Options University’s Options Mastery course, this relationship is expressed in a formula: Call price-Put price= Stock price-Strike price.
 
So, when we look at this base formula and we see the call price minus the put price, what we’re doing is canceling out the extrinsic value of that strike and only leaving the intrinsic value of that strike. When we do this, we are left with just intrinsic value of the strike. After all, only one of the corresponding call or put can have intrinsic value.
 
Likewise, when we subtract the strike price from the stock price, we are left with intrinsic value if the strike is in the money.
 
The following example taken from the Mastery Course will help to prove the point. For example, let’s take the June 70 calls with the stock at $69.50. From here let’s go back and plug in our numbers and see what we get. We’ll go back for our call price and put price but we know the strike price was $70 and we know that our stock price is $69.50. What type of value do we get, a minus .50 cents, simple math.
 
Now, let’s look at our call price minus our put price. Our call price is going to be $1.65 and our put price is going to be $2.09, so let’s plug that in, $1.65 for the call and $2.09 for the put. What we come up with is a minus .44 cents. You may say wait, the two of those aren’t equal. That’s because we haven’t adjusted for interest rate and dividend. The bottom line is that if you buy a call and sell the corresponding put, it will create a long synthetic stock position; however, there is no adjustment for interest rate or dividends.
 
Of course, the same holds true if you want to create a short synthetic stock; buy the put and sell the call. Moreover, we can create the six synthetic stock positions. For example, by either buying stock and buying puts, which will give a long call position, we can create a short call by selling the stock and selling the put. You can create a long put by selling the put and buying a call. Key to making this work is using corresponding options in a one to one ratio.
 
According to Ron Ianieri, author of the Mastery Course, “These six majors are critical because everything else that we’re going to be doing is going to involve synthetic relationships at some level. This is what separates the men from the boys and the women from the girls. This is what separates people that really understand what they’re doing in options and those who don’t. This is what separates the people who make money in options and the people who lose money in options.”
 
For information on everything stock options, contact the Options University at:

www.optionsuniversity.com

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