With an understanding of terms and definitions involved in synthetic options, how do traders begin applying synthetic options in the most efficient way?
Now that you know the basic terms and definitions involved in synthetic options strategies, let’s take this discussion to the application stage. How can options traders begin applying synthetic options in an efficient way?
In part 1 of this discussion, Peter Klink pointed out that a covered call position (long stock + short call) is the synthetic equivalent option strategy to selling a put. (Review part 2 here.) Now, if I am an investor who would like to buy a stock (say, AAPL trading at $107), but don’t want to buy it at that price, I might place a limit order to buy that’s “good ’til canceled” (GTC) at the desired lower price and wait for that order to eventually fill (with no guarantee that will happen). But synthetic option strategies can provide another alternative.
If a covered call position has the same risk profile as a short put, then I can use the short put instead of a limit order to synthetically create a covered call position. If I decide I want my entry price for AAPL to be $100, then by selling the May 16 100 put for $1.30, I can receive a premium and hope that AAPL retreats to that below $100 resulting in an assignment. If during this period AAPL does not decline to that price, I keep the premium, I received from selling the put resulting in an effective entry price of $98.70 per share (100 strike – $1.30 premium on short put, plus transaction costs).
Here's another scenario. What if AAPL takes six months to retreat to the $100 level? If a trader sold the 30-day 100-strike put six times over the course of six months for an average price of $1.25, he could theoretically lower the effective price per share to $92.50 ($1.25 x 6 = $7.50, plus transaction cost). Of course there's no guarantee that he'll be able to do this consistently month after month for six months.
There are several ways to increase, decrease, or define the risk in a short put strategy. Strike selection can be used to adjust the overall risk to the size and risk tolerance of your account. The use of a short put vertical spread strategy would help limit the downside exposure to the width of the strikes minus the net credit received for the spread, minus transaction costs. A trader could also use a rolling strategy (buying to close the short put and selling a longer-dated put) to add duration and adjust short strike prices if, as expiration nears, she would rather continue with the same strategy for a longer duration.
FIGURE 1: AAPL SHORT PUT.
This chart shows the potential profit and loss of a May 16 100-strike put in AAPL based on different scenarios in the stock. Click the Analyze tab in thinkorswim® to perform a similar analysis. Chart source: the thinkorswim® platform by TD Ameritrade. Data source: CBOE. Not a recommendation. For illustrative purposes only. Past performance does not guarantee future results.
Once AAPL (or any underlying stock—these strategies are indifferent to stock choice) breaks the $100 level, if it ever does, the trader would then likely be assigned the stock at $100 per share, less the premium collected on the put sales (minus any transaction fees). She could then execute the second leg of the strategy and sell a covered call on the newly purchased shares of stock.
To do this, she would select a strike price, choose the duration of the strategy, and sell the call against the recently acquired stock. This approach reduces the net effective cost (net purchase price of the stock) by the premium collected, still experiences positive daily decay theta, and has a future sale price of the strike price of the option plus the net premium collected for the short call. The advantage to this covered call strategy is that, unlike the short put, the trader participates in any stock dividends that may take place during the life of the transaction. The trader could get assigned on the call prior to the ex-dividend day and lose eligibility for the dividend.
The short put strategy includes a high risk of purchasing the corresponding stock at the strike price when the market price of the stock will likely be lower.
Spreads and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return.
Rolling strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return.