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The Fine Art of Synthetics

I am reading a book by Charles Cattle (2006) called “Options Trading: The Hidden Reality”. It is a nice introduction into the art of synthetics – which is basically the study of alternatives and relations between different configurations of portfolios that involve options.

The idea is to find equivalent alternatives to certain portfolio constellations from the risk point of view. Consider the following example from the book:

You want to write a covered call by going short with 90 calls for 9$ and going long in the underlying instrument for 96$. At this point you have made 3$ and it will stay this way unless the price of the underlying falls below 90$. The question is: would you want to go short with 90 puts naked for 3$ instead? As you may have noticed, these trades are completely equivalent at expiration from the risk point of view.

The fundamental equation in synthetics is: +u -c = -p (buying an underlying and selling calls is the same as selling puts).

One may wonder what the benefit of knowing such “alternatives” is. Well, first of all, although these positions offer the same risk profile at expiration, they are pretty different in other areas.For example, in the first case you have to perform two trades, in the second case only one. There is already a benefit regarding the brokerage costs.

Furthermore, in the first case you have to invest a net amount of 87$. If you were lucky to get a profit of 3$, it would mean a mere 3.45% return on investment. In the second case though, you do not have to invest anything (making ROI an infinite number ).

Synthetics get pretty interesting when you start to think about how you could lock in profit in certain situations for a given portfolio. We’ll take a look at it at a later point of time … !