Synthetic Option Trades

Published on: Jan 30 2013 by John Critchley

Use Synthetic Option Trades

Try using synthetic put options.  Why should you consider using them and what are synthetic options?

Why? The Answer: There are two main reasons to consider the use of synthetic option trades.

1)      Liquidity- There may be circumstances whereas there is more liquidity and a tighter spread in the call options then in the put options.  This is not uncommon in times of extreme stress and high implied volatility in the marketplace.  The customer is able to get a ‘better’ price by doing a synthetic trade.

2)       Pros use synthetics options to help disguise the intention or bias of a trade. Why not the retail customer?

As option trading data becomes more and more readily available to the general public, there is a desire among professional and retail traders to disguise the intent or bias of an option purchase or sale.   Back in the good ‘ole days of option trading in the 1980’s, 90’s and early 2000’s, a professional option trader could get a feel for institutional bias in an underlying by the paper flow of the option trades.  If a customer came in to buy a large block of calls, the best bet was that the underlying was going to move sharply higher.  Conversely a large put trade was a very bearish signal.   However, as the option marketplace matured and institutional and retail order flow became more sophisticated, this reading of ‘paper flow’ became more difficult.  Why?  Let’s examine the reason:


Synthetic Positions

A common refrain among professional option traders and market makers is that “Calls are Puts, Puts are Calls”. 

The key point in understanding synthetics option positions is in the basic underlying tenant of option pricing which is put/call parity.   If one is properly assessing a position, it is not that important what the individual call and put positions of that line are, but what is most paramount is the net combined position of that line.  What that means in essence is that calls or puts that are properly hedged are turned synthetically into each other.

Example:

1) Buy 100 NFLX Apr 200 Calls at $16.50

Hedge is:    Sell 10,000 NFLX underlying at $210.00

Synthetically created a position of:   Long 100 Apr 200 Puts

Let’s Test this Trade- NFLX goes to $150.  What happens?

NFLX 200 Calls = 0           $16.50 X 10,000           Lose $-165,000

NFLX Underlying= $150    10,000 X$ 60               Make $600,000

Net + $ 435,000 Profit          

2) Now let’s straight   Buy 100 Apr 200 puts at $ 6.85

Let’s Test this Trade – NFLX goes to $150.  What happens?

NFLX 200 Puts =    200(strike price) -$150 (new underlying price) = $50

Same approx result as above-     $50 – premium paid ($6.85) X 10,000   =

Net +$431,500 Profit

As we can see, the net result of doing a ‘synthetic put’ is essentially the same as doing a straight buy of the puts.

Note:  This type of trade is advisable only if the tighter spread in the calls versus the puts and less slippage in putting on a trade will help offset the extra commission incurred by executing a two sided trade or if the customer wishes to disguise the bias of their trade.

The same synthetic creation will occur on the call side if we Buy Puts and Buy Stock to create a synthetically Long Call Position.

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