In our last look at synthetics, we reviewed a list of options trades compared to their “synthetic” counterparts—different sets of trades that have similar profit/loss and risk profiles. We saw that, depending on a trader’s existing positions, synthetics can offer alternatives for changing things up—going long or short—while potentially saving on transaction costs. Read that article here.
Now let’s take a look at two other potential benefits of synthetic positions: efficient price discovery and efficient use of capital.
Efficient Price Discovery
As I mentioned in Part 1, floor traders originally used synthetics to price options and for arbitrage. Of course, it’s almost impossible now for human traders to take advantage of price discrepancies between synthetics and regular options strategies. Nowadays, these arbitrage opportunities exist only for milliseconds before computer-driven market-making captures them.
Nevertheless, it can be helpful to understand how options are priced based off synthetics, especially if the bid/ask spreads are wider on one side of the market. Let’s look at an example to see why.
Suppose FAHN is trading at $126. The 125 strike call is trading at $1.50, and the 125 strike put is trading at $0.50. The synthetic stock or combo would equal the difference of the underlying:
Call at $1.50 – put at $0.50 = $1.00
Add $1 to strike (125) = $126
A trader who understands this relationship might be better informed when considering the call or put price versus the expected price of the corresponding option in the same month and at the same strike price.
Efficient Use of Capital
Synthetic options strategies can also potentially help traders use capital more efficiently. This has to do with margin requirements and is best explained with another example.
Suppose a trader is holding a covered call position in XYZ. The trade is constructed by buying 100 shares of XYZ at $120 and selling one 120 call at $6.50. The margin requirement is typically 30%. So, for this example covered call, the margin requirement would be $3,600.
A covered call (long stock + short call) has a synthetic equivalent in the form of a short put. Let’s assume the 120 put is trading at $6.50. The margin requirement for this short put is $3,050.
The margin requirement for a short put is typically 20%, which is less than the margin requirement for the covered call and stock position. Yet, the two trades have similar profit/loss and risk profiles. Importantly, most traders need a margin account to achieve these breaks in margin requirements.
Understanding these dynamics of synthetics and margin requirements can potentially add flexibility to trading options. Sticking with the same covered call example, suppose the trader chooses to enter a short put instead of the covered call, taking advantage of the lower margin requirement. Now the trader has one leg (a single option position) to manage, instead of unwinding two legs (the long stock + short call).
Please note: We're using TD Ameritrade's requirements for a standard margin account and they're different than the industry requirements.
The Bottom Line on Synthetics
By understanding the fundamentals of synthetics, options traders can potentially reduce transaction costs, use capital more efficiently, and add flexibility to positioning and market exposure. Keep in mind that the examples here do not take into account dividends, interest rates, and options expiration pin risk.
A covered call strategy can limit the upside potential of the underlying stock position, as the stock would likely be called away in the event of a substantial stock price increase.
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.
Intrigued by the possible benefits of understanding synthetics? Here are a couple more Ticker Tape articles to help you explore further:
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