3 Ways to Trade “Long Synthetics”

05/13/2011 5:00 am EST

Focus: OPTIONS

Josip Causic

Instructor, Online Trading Academy

While they contradict certain principles of good option trading, Long Synthetics can increase both protection and delta in a profitable way.

One of the option strategies that we teach in our live option course, specifically on Day 4, is known as a Long Synthetic. The Long Synthetic strategy creates the same effect as holding the underlying asset but ties up less capital as compared to buying the underlying outright.

Although this option strategy will make us virtually the same, penny for penny, as owning the underlying, it does not allow ownership voting rights or receive any dividend payouts.

This article will zoom in only on the specific aspect of selecting optimum strikes for a Long Synthetic. It will assume that we have already selected an optionable underlying with strong fundamentals and bullish technicals. Also, the volatility reading will be taken out of the equation.

The figure below points out how much capital would be tied up if you purchased 100 shares of an underlying that trades at $36.10:

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If you have a margin account, the capital required may be half, but depending on your broker and type of account, the Long Synthetic requires even less margin. Also, depending on your broker, commissions could be significantly lower using options compared to purchasing the stock.

If the trader chooses to purchase 100 shares of the underlying, then by default the trader has 100 deltas (though most equity traders do not look at their stock ownership as positive deltas). In other words, if the underlying moves up, then the trader makes 100% of its upward move; hence, the delta of 100.

Figure 1 does not include a breakeven point (BEP), which in the case of stock is the exact purchase price. Conversely, the other three option choices (Figure 2 to 4) will have BEP listed in their figures.

No. 1 Choice: At the Money (ATM)
Near-the-money choice: Synthetic Long = short ATM (at-the-money) put [+.50 delta] and long ATM call [+.50 delta]

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The first Long Synthetic choice (shown above) involves the at-the-money long call and short put. When the premiums were pulled out of the option chain for both calls and puts, the following was given: The ATM 36 put at the bid was trading for 1.20, and when the put is sold, its delta is positive; hence, +47 on the figure above.

The positive-53 delta came from the ATM 36 call, and when both deltas are added, their aggregate amount is exactly 100—which means if the underlying asset goes up a penny, so does the Long Synthetic. Below the actual current stock price, at 35.97, the combined BEP on this position (strike price plus premium) is lower than the strike price, since the premium is actually a credit of 3 cents.

NEXT: No. 2 Choice: Out of the Money

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No. 2 Choice: Out of the Money / In the Money (OTM/ITM)
One step OTM (out-of-the money) / ITM (in-the-money) choice: Synthetic Long = short OTM put [+33 delta] and long ITM call [+.67 delta]

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The second choice (shown above) involves one-step OTM/ITM strikes. The 35 put is out-of-the money with the delta lower than 50, which is normal. The ATM strikes usually have a delta near 50, OTM strikes have less delta, and in our case, the 35 put has only 33 deltas. However, the 35 call is ITM and has a higher delta. Again, the combined deltas of both options produce virtually the same effect as owning the stock.

The total cost of doing this trade would be $120. The combined BEP is 36.20, a little higher than where the stock is currently trading.

#3 Choice: 2 Steps Out
Two steps OTM/ITM choice: Synthetic Long = short 2 x OTM put [+21 delta] and long 2 x ITM call [+.79 delta]

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The third choice involves strikes that are further away from the current price, and again, their cumulative delta is positive-100. The total cost of doing this trade is 204. Also, the BEP is 36.04.

Going quickly through each of these three option possibilities, except the first choice of buying the underlying, I wish to focus on the pros and cons on the obligation (sold put).

The put in the first option choice (ATM call and put), as presented in Figure 2, has a high chance of getting hit. At the time, the underlying was trading at 36.10, and the seller would be taking up the obligation to buy it at 36. It is easily possible for the asset to drop 10 cents over the next month, and then the obligation of buying at 36 needs to be performed regardless of how much lower than 36 the underlying is trading.

The second option choice, involving an OTM put and ITM call (Figure 3) gives a bit more protection from the possibility of assignment, and gives a bit more delta to the calls.

The third option choice (Figure 4) gives even more protection from assignment and an even higher call delta. Out of these three, we could classify them in the following ways.

  • First (worst) choice: saved a bit of money on the call side because the lower call delta was purchased, and on the put side, it has juicy premium. But assignment is not far away.
  • Second (bad) choice: on the call side, the higher delta was purchased, which gave us an advantage. However, on the put side, the premiums were not so juicy.
  • Third (good) choice: the put premium still had some value and the calls gave us the highest delta.

Having explained the selection of a Long Synthetic, let me wrap up by stating that a Long Synthetic contradicts some of the essentials of Online Trading Academy teachings.

For instance, we teach that when buying, we should buy deep ITM options with 60-plus days out when the IV is low. We also teach that when selling, we should be selling when the IV is high (or in a higher range) with the shortest possible time to expiration, front month mostly.

The contradiction lies in the fact that a Long Synthetic involves the selling of a put and the buying of a call. In the case above, we sold a put (front month correctly), but the IV was not in the higher range. This could be construed as an error. On the call side, we did get an ITM call, but did not go out 60 days; hence, another contradiction. Obviously, we cannot have both high volatility and low at the same time.

So, when trading options, there will always be some give and take, so do not get discouraged. Aim to go as close as possible to an ideal and be happy with it.

Josip Causic is an instructor for Online Trading Academy.

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