Understanding Synthetic Options

Options are touted as one of the most common ways to profit from market swings. Whether you are interested in trading futures, currencies or want to buy shares of a corporation, options offer a low-cost way to make an investment with less capital. While options have the ability to limit a trader's total investment, options also expose traders to volatility, risk, and adverse opportunity cost. Given these limitations, a synthetic option may be the best choice when making exploratory trades or establishing trading positions.

There is no question that options have the ability to limit investment risk. If an option costs $500, the maximum that can be lost is $500. A defining principle of an option is its ability to provide unlimited opportunity for profit with limited risk. However, this safety net comes with a cost because many studies indicate the vast majority of options held until expiration expire worthless. Faced with these sobering statistics, it is difficult for a trader to feel comfortable buying and holding an option for too long. See: Using Options Instead Of Equity

Options "Greeks" complicate this risk equation. The Greeks - delta, gamma, vega, theta and rho - measure different levels of risk in an option. Each one of the Greeks adds a different level of complexity to the decision-making process. The Greeks are designed to assess the various levels of volatility, time decay and the underlying asset in relation to the option. The Greeks make choosing the right option a difficult task because there is the constant fear that you are paying too much or that the option will lose value before you have a chance to gain profits.

Finally, purchasing any type of option is a mixture of guesswork and forecasting. There is a talent in understanding what makes one option strike price better than another strike price. Once a strike price is chosen, it is a definitive financial commitment and the trader must assume the underlying asset will reach the strike price and exceed it to book a profit. If the wrong strike price is chosen, the entire strategy will most likely fail. This can be quite frustrating, particularly when a trader is right about the market's direction but picks the wrong strike price. See: Getting To Know The "Greeks"

Many problems can be minimized or eliminated when a trader uses a synthetic option instead of purchasing a vanilla option. A synthetic option is less affected by the problem of options expiring worthless; in fact, adverse statistics can work in a synthetic's favor because volatility, decay and strike price play a less important role in its ultimate outcome.

There are two types of synthetic options: synthetic calls and synthetic puts. Both types require a cash or futures position combined with an option. The cash or futures position is the primary position and the option is the protective position. Being long in the cash or futures position and purchasing a put option is known as a synthetic call. A short cash or futures position combined with the purchase of a call option is known as a synthetic put.

Example - A Synthetic Call Assume the price of corn is at $5.60 and market sentiment has a long side bias. You have two choices: you can purchase the futures position and put up $1,350 in margin or buy a call for $3,000. While the outright futures contract requires less than the call option, you'll have unlimited exposure to risk. The call option can limit risk but is $3,000 is a fair price to pay for an at-the-money option and, if the market starts to move down, how much of the premium will be lost and how quickly will it be lost? A synthetic call lets a trader put on a long futures contract at a special spread margin rate. It is important to note that most clearing firms consider synthetic positions less risky than outright futures positions and therefore require lower margin. In fact, there can be a margin discount of 50% or more, depending on volatility.  Let's assume a $1,000 margin discount in this example. This special margin rate allows traders to put on a long futures contract for only $300. A protective put can then be purchased for only $2,000 and the cost of the synthetic call position becomes $2,300. Compare this to the $3,000 for a call option alone, booking is an immediate $700 savings. 

A synthetic call or put mimics the unlimited profit potential and limited loss of a regular put or call option without the restriction of having to pick a strike price. At the same time, synthetic positions are able to curb the unlimited risk that a cash or futures position has when traded without offsetting risk. Essentially, a synthetic option has the ability to give traders the best of both worlds while diminishing some of the pain. 

While synthetic options have superior qualities compared to regular options, that doesn't mean that they don't generate their own set of problems. 

If the market begins to move against a cash or futures position it is losing money in real time. With the protective option in place, the hope is that the option will move up in value at the same speed to cover the losses. This is best accomplished with an at-the-money option but they are more expensive than an out-of-the-money option. In turn, this can have an adverse effect on the amount of capital committed to a trade.

Even with an at-the-money option protecting against losses, the trader must have a money management strategy to determine when to get out of the cash or futures position. Without a plan to limit losses, he or she can miss an opportunity to switch a losing synthetic position to a profitable one. See: Money Management Matters In Futures Trading

Also, if the market has little to no activity, the at-the-money option can begin to lose value due to time decay. 

It's refreshing to participate in option trading without having to sift through a lot of information in order to make a decision. When done right, synthetic options have the ability to do just that: simplify decisions, make trading less expensive and help to manage positions more effectively.