Really Pretty Real: Understanding Synthetic Options Strategies, Pt 1

Learn how synthetic options strategies can help traders potentially lower transaction costs, improve price discovery, and more efficiently use capital.

Print
https://tickertapecdn.tdameritrade.com/assets/images/pages/md/Human and robot: Most arbitrage opportunities have given way to computerized trading ... but synthetics are still relevant
4 min read

Back before option pricing models and mathematical greeks—we’re talking delta, gamma, theta, vega, and rho, not the ancient Greeks (Socrates, Aristotle, Plato)—floor traders used synthetic positions to price options. Synthetics are positions that mimic the risk/reward profile of another position, typically using some combination of stock and options. Understanding synthetics gave those floor traders a strong foundation and deep knowledge of options. I want to help you gain the same insight into options strategies by explaining how to use and interpret synthetics.

Back in the day, floor traders used synthetic positions for arbitrage, which is a trading strategy that seeks to lock in a risk-free profit by buying one investment and simultaneously selling a similar or related investment at a different price. This arbitrage was available in the early days to options traders on the floors of the exchanges. But today, with the increase in computing power and brilliant PhDs coding algorithmic trading strategies, these arbitrage opportunities are difficult to come by for the remaining floor traders and for retail traders trading from their screens.

Nevertheless, understanding synthetics still offers the options trader several potential benefits:

  1. They can help lower transaction costs
  2. They can help with efficient price discovery
  3. They can provide more efficient use of capital and flexibility

The Skinny on Synthetics

Before we get into the details of how these benefits work, let’s take a minute to relate synthetics to plain-vanilla options strategies. This is really quite simple. Ordinary options strategies with the same strike price and expiration month all have synthetic equivalents. And because of the relationship between calls, puts, and their respective underlying stocks, synthetics have profit/loss and risk profiles that are similar to regular options.

Option Position Synthetic Position
Long call Long put + long stock
Long call Long stock + long put
Long put Long call + short stock
Short call Short stock + short put
Short put
Long stock + short call
Long stock Long call + short put
Short stock Long put + short call
Long straddle Short stock + long 2 calls
Short straddle Long stock + short 2 calls
Short put vertical Long call vertical: same strikes
Short call vertical Long put vertical: same strikes

Fewer Transaction Costs

Because of these relationships, synthetics can be used to express changing opinions about the direction of the market without closing out an existing plain-vanilla trade. By executing fewer trades, traders can potentially save on transaction costs. Let’s walk through some examples to see where the savings might come from.

Suppose a trader is already long a put, but he thinks the market might go higher and wants to get bullish, too. He could sell the put and buy a call, which would incur two commission fees. Or, he could buy the underlying stock and hold on to the put. That’s just one commission. This works because a long stock + long put on the same strike and month is equivalent to a long call.

Here’s another scenario. Suppose a trader is long a call and decides to get short the market. Instead of selling the call and buying a put, it might be cheaper to short the stock and hold the call. A long call + short stock on the same strike and month is equivalent to a long put.

What if a trader is unsure about direction, but wants to express an opinion about changing volatility?

Say the trader is long two calls. She’s unsure about which way the stock might move, but she thinks it could be a big move in a short time period. Maybe there’s an earnings announcement, court case, or some other binary event coming up. She could enter a long straddle to potentially profit from an increase in volatility. Instead of buying two puts, she could short the stock, because short stock + long two calls is equivalent to a long straddle.

Suppose a trader is short two calls and is unsure about direction, but he thinks the stock might experience a small move in the short term. He wants to enter a short straddle. Instead of shorting two puts, he could buy the stock. Long stock + short two calls is equivalent to a short straddle.

All clear yet? Synthetics can seem confusing, but they’re really just different ways of looking at—or possibly trading—a position with the same profit/loss and risk profile. We’ve seen how synthetics can potentially offer fewer transaction costs versus trading garden-variety options. In Part 2, we’ll look at how synthetics can offer a couple more benefits: efficient price discovery and efficient use of capital.

Spreads, Straddles, and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades.

Learn From an Options Trading Leader

Whether you’re an equity trader new to options trading or a seasoned veteran, TD Ameritrade can help you pursue options trading strategies.

Call Us
800-454-9272
adChoicesAdChoices

Market volatility, volume, and system availability may delay account access and trade executions.

Past performance of a security or strategy does not guarantee future results or success.

Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.

Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.

The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.

This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.

TD Ameritrade, Inc., member FINRA/SIPC. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2018 TD Ameritrade.

Scroll to Top