Not So Artificial: Understanding Synthetic Options Strategies

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/Synthetics: Learn the benefits of why synthetic positions can work even better than the real thing.
3 min read

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

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:

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