Option Synthetics

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Option Synthetics

• Option Synthetics The Building Blocks of
  Options Strategies

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Required Reading
For the sake of simplicity, the examples that
follow do not take into consideration commissions
and other transaction fees, tax considerations,
or margin requirements, which are factors that
may significantly affect the economic
consequences of a given strategy. An investor
should review transaction costs, margin
requirements and tax considerations with a broker
and tax advisor before entering into any options
strategy. Options involve risk and are not
suitable for everyone. Prior to buying or
selling an option, a person must receive a copy
of CHARACTERISTICS AND RISKS OF STANDARDIZED
OPTIONS. Copies have been provided for you today
and may be obtained from your broker, one of the
exchanges or The Options Clearing Corporation. A
prospectus, which discusses the role of The
Options Clearing Corporation, is also available,
without charge, upon request at 1-888-OPTIONS or
www.888options.com. Any strategies discussed,
including examples using actual securities price
data, are strictly for illustrative and
educational purposes and are not to be construed
as an endorsement, recommendation or solicitation
to buy or sell securities.
For the sake of simplicity, the examples that
follow do not take into consideration commissions
and other transaction fees, tax considerations,
or margin requirements, which are factors that
may significantly affect the economic
consequences of a given strategy. An investor
should review transaction costs, margin
requirements and tax considerations with a broker
and tax advisor before entering into any options
strategy. Options involve risk and are not
suitable for everyone. Prior to buying or
selling an option, a person must receive a copy
of CHARACTERISTICS AND RISKS OF STANDARDIZED
OPTIONS. Copies have been provided for you today
and may be obtained from your broker, one of the
exchanges or The Options Clearing Corporation. A
prospectus, which discusses the role of The
Options Clearing Corporation, is also available,
without charge, upon request at 1-888-OPTIONS or
www.888options.com. Any strategies discussed,
including examples using actual securities price
data, are strictly for illustrative and
educational purposes and are not to be construed
as an endorsement, recommendation or solicitation
to buy or sell securities.

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Tradeoffs

• Risk and reward must be balanced in all option
  trades
• The probability of profit and the potential for
  profit or loss must be considered

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Review

• Options have value for two reasons, potential
  price change (volatility) and the cost of carry
  (risk free interest rates and dividends)

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Cost of money

• If an investor bought a 100 stock last year and
  the stock was trading at 100 today, did the
  investor lose money?

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Synthetics are the Foundations of Options

• A further understanding of these relationships
  will enhance overall options knowledge
• Calls can easily be built to act like puts and
  puts can be built to act like calls
• Market forces ensure fair pricing for market
  participants by engaging in options arbitrage
• Three examples are synthetic call, synthetic long
  put and synthetic short put

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Synthetic Long Call

• Long stock and long put builds a synthetic long
  call
• The risk/reward balance are nearly identical to
  plain long calls
• The purchase of the put insures the downside
  selling price but increases the breakeven amount

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Plain Long Call
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Long Stock
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Long Put
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Long Stock and Long Put
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Synthetic Long Call Long Stock and Long Put
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Synthetic Long Put

• Short stock and long call builds a synthetic long
  put
• Risk/reward is nearly identical to plain vanilla
  long put
• The purchase of a call combined with a short
  stock position insures the upside buying price
  but increases the breakeven amount

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Plain Long Put
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Short Stock
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Long Call
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Short Stock Long Call
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Synthetic Long Put Short Stock and Long Call
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Synthetic Short Put

• A Covered Call, long stock aggregated with a call
  sold
• The risk/reward is very similar to a short put
• Substantial downside risk with a limited upside
  potential

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Plain Short Put
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Long Stock
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Sell Call
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Covered Call
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Synthetic Short Put Covered Call
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Put-Call Parity

• Put Present value of strike call stock
• Early exercise complications must always be
  considered
• Borrowing and lending rates and dividends are
  important factors

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Refresher What is Present Value?

• Money earned today is worth more than money
  earned next year due to compounding of interest
• Assets have carrying costs an opportunity cost
  that is foregone, this carrying cost is vital for
  options
• Option synthetics include this cost using the
  present value of the strike price

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Synthetic Equations

• Stock Put Discounted strike Call
• Stock Put Treasury Bill Call
• Note the strike price is effectively reduced by
  amount of money that can be earned risk-free
• The amount of the discount is the strike price
  risk-free rate days to expiration/365

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Synthetic Call Relative to Plain Call

• Stock is 20 and the strike price is 20
• Present value of strike effectively discounts the
  strike
• Cost of carry (discounted strike) Principal
  Rate Time (55 days .05)
• Call is 1.15, Put is 1.00
• Using the aforementioned formula, Stock Put
  T-Bill, (discounted strike) Call
• 20.00 1.00 19.85 1.15

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Additional Complications

• Margin rates
• Commissions
• Taxes
• Changing dividends and interest rates
• Corporate actions
• Exercise and assignment risks

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Cash Flow Examples

• If we were to buy XYZ at 20.00 and buy the XYZ
  55 day 20 strike put for 1.00 your cash flow
  invested would be 21.00 with the ability to sell
  XYZ at 20 anytime until expiration (the long
  put)
• If we were to buy XYZ call at 1.15 the remaining
  proceeds (19.85) can be invested at a risk-free
  rate that would generate .15 of income or a total
  cost of 1.00
• The cash flows are identical, the risk and reward
  tradeoffs are identical

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No Arbitrage Opportunities

• There is very little chance to take advantage of
  pricing anomalies
• Calls that appear more expensive relative to
  puts are normally not more expensive
• Cost of carry creates these illusions, the higher
  the price of the stock the greater the cost of
  carry

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Professional terminologyConversions and
Reversals

• Professionals arbitrage call and puts to keep
  them at relative value with each other
• Conversion Buy stock, buy put, sell call
• Reversal Sell stock, sell put, buy call

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Examples

• Buy stock _at_20, buy 55 day put for 1, sell call
  for (1.15), what is your carry cost? 20.05
  55 days/365 calendar days .15 cost of carry
  (conversion)
• Sell stock _at_20 sell put 1.00, buy call 1.15,
  what is the carry cost? 20 1.00 carry
  rebate .15 1.15 for purchased call 0
  (reversal)
• Assumes European exercise (equity options are all
  American style and therefore have early exercise
  risk)
• Also assumes stock can be shorted, and borrowing
  and lending are the same (this is normally not
  true)

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Risk/Reward is the Key

• Option synthetic relationships give investors
  insight into the options marketplace
• Put-Call parity allows investors the ability to
  value puts if they know the call price or
  vice-versa
• The risk/reward of each trade must be weighed to
  determine if the trading strategies considered
  meet your own investment goals
• The probability of profit and the potential for
  profit or loss must be considered

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ISE Website

• ISEoptions.com- Valuable product, educational
  information and market data information is
  available