Synthetic Option Hedging

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Synthetic Option Hedging
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• Options can be used in various combinations of
  strategies that will mimic futures hedges. When
  they correctly mimic a futures hedge, they are
  called a synthetic hedge.
• For a synthetic short futures hedge, the option
  strategy would be the simultaneous buying a put
  and selling a call at the same strike price.

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Synthetic Short Futures Hedge
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Synthetic Long Hedge

• A synthetic long futures hedge involves
  simultaneously buying a call and selling a put at
  the same strike price

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Synthetic Long Futures Hedge
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Synthetic Option vs Futures

• With a synthetic option you are paying two
  commissions to the broker, whereas with a futures
  hedge you pay only one commission.
• The trader is subject to margin calls with both a
  futures hedge and a synthetic hedge because he
  has sold an option.
• Most synthetic hedges do not offer any advantages
  over a traditional futures hedge.
• A simple variation of the synthetic short hedge
  is to buy a put and sell a call at different
  strike prices such that a positive premium is
  earned up front.

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Price Insurance

• Insurance involves the idea that a level of
  protection is provided when needed for a premium
  to the buyer.
• Options provide this insurance function with
  respect to price protection.
• However, futures hedging provides price
  protection when it is needed and when it is not.
• On the other hand, an option buyer can exercise
  the option or let it expire, thus receiving price
  protection both when it is needed and ignoring
  the option when the protection is not needed.

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• It should be clear from the previous table that
  options provide the function of price insurance.
• It is also shown in the table that when the price
  moves in the favor of the cash position, a trader
  would like to be hedged with an option versus a
  futures contract, but would really prefer to be
  unhedged.
• Thus, an option hedge is second best to being
  unhedged if price moves in favor of the cash
  position.

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Exotic Options
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• The options we have covered so far are termed
  plain vanilla products.
• Exotic options are variations on the standard
  call and put options.
• In this section, we focus on number of different
  types of exotic options that large investments
  banks offer on underlying assets such as stocks,
  stock indices and currencies.

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Packages

• A package is a portfolio consisting of standard
  European call, standard European puts, forward
  contracts, cash and the underlying assets itself.
• Examples Bull spread, bear spreads, butterfly
  spreads, calendar spreads, straddle, strangles
  and so on.

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Packages

• Often a package is structured by traders so that
  it has zero cost initially. An example is a
  range-forward contract.
• A short-range forward contract consists of a long
  position in a put with a low strike price and
  short position in a call with a high strike
  price.
• The price of the call equals the price of the put
  when the contract is initiated.

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Nonstandard American Options

• In practice, the American options that are traded
  in the over-the-counter market do not always have
  these standard features.
• For example
• Early exercise may be restricted to certain
  dates. The instrument is known as a Bermuda
  Option.
• Early exercise may be allowed during only part of
  the life of the option.
• The strike price may change during the life of
  the option.

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Compound Options

• Compound options are options on options.There are
  four main types of compound options
• A call on a call
• A call on a put
• A put on a put
• A put on a call
• Compound options have two strike prices and two
  exercise dates.

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Compound Options

• Call on a call Gives the holder to pay the first
  strike price and receive a call option.
• A compound option is much more sensitivity to
  volatility than a plain vanilla option.

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A Chooser Option

• A chooser option (sometimes referred to as an as
  you like option) has the feature that after a
  specified period of time, the holder can choose
  whether the option is a call or a put.

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Binary options

• A binary options are options with discontinuous
  payoffs.
• A simple example of a binary option is a
  cash-or-nothing call.
• The payoff is nothing if the stock price ends up
  below the strike price at time T and pays a fixed
  amount, if it ends up above the strike price.

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Shout options

• A shout option is a European option where the
  holder can shout to the writer at one time
  during its life. At the end of the life of the
  option, the option holder receives either the
  usual payoff from a European option or the
  intrinsic value at the time of the shout,
  whichever is greater.
• Suppose the strike price is 50 and the holder of
  a call shouts when the price of the underlying
  asset is 60. If the final asset price is less
  than 60, the holder receives a payoff of 10.

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Asian options

• Asian options are options where the payoff
  depends on the average price of the underlying
  asset during at least some part of the life of
  the option.
• The payoff from an average call is max(0, Save-X)
• The payoff from an average put is max(
• These options are less expensive than regular
  options.