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Synthetic Options Spread A Guide for Traders

15 Jun 2023

Introduction

Synthetic options spread have become quite popular amongst investors. It entails smartly combining various options contracts to replicate the options spread. But how can investors modify their strategies and adjust to changing market conditions using synthetic options spreads? What benefits does it provide? What risks and factors should investors be aware of? Let’s break down how exactly synthetic options spread work.

What do you mean by synthetic options spread?

One of the most popular ways to profit from market fluctuations is via options. Options offer a cost-efficient alternative to investing with less capital. However, options also subject investors to market volatility and associated risks. As a result, synthetic options might be the ideal alternative when placing trades or opening trading positions. 

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The chances of options expiring valueless have less of an impact on synthetic options. Negative fluctuations work in a synthetic option's favor since volatility and strike price have less effect on the end result.

What are the different types of synthetic options?

Synthetic calls and synthetic puts are the two synthetic options. Both require a position in cash or futures alongside an option. 

  • Synthetic Call: When an investor considers being long in the cash or futures position and buys a put option, it is a synthetic call. It is an options strategy that mirrors the performance of a call option by using shares and a put option. As a result, the investor has limitless potential for growth, with minimal risk. 
  • Synthetic Put: When an investor considers being short in the cash or futures position and buys a call option, it is a synthetic put. It is an options strategy that mirrors the performance of a put option by combining stock shares and a call option. As a result, the investor is safe against a stock price hike.

What is a put call parity?

Synthetics are created when calls, puts, and stocks are combined and contrasted under options. The ability to purchase a stock (the call option), sell a stock (the put option), and the actual stock all have a close connection. Due to this link, any two can be combined to reflect the risk profile of the third.

For example, let’s consider the Big 6 – 

  1. Long Call – Long Put + Long Stock
  2. Short Call – Short Put + Short Stock
  3. Long Put – Long Call + Short Stock
  4. Short Put – Short Call + Long Stock
  5. Long Stock (Underlying) – Long Call + Short Put
  6. Short Stock (Underlying) – Short Call + Long Put

This concept describes how the prices of put and call options under the same class relate, i.e., having similar underlying assets, strike price, and expiration date.

How does this relationship work?

Scenario 1

An investor who wants a long put, predicts the market might rise. In this case, they can purchase a call and sell a put. But it would cost them two commissions to fulfil this transaction. So they can keep the put while purchasing the underlying stock. It leaves the investor with just one transaction. This strategy works because a long stock with a long put at the same strike and month equals a long call.

Scenario 2 

An investor wants to short the market while they are looking for a long call. In this case, they can sell a call and purchase a put. However, this would be an expensive move for the investor. Alternatively, the investor can short the stock and hold the call. This strategy works because a short stock with a long call at the same strike and month equals a long put.

The counting decision 

Investors can move confidently through the complex world of options trading if they thoroughly understand the working of synthetic options spreads. The flexibility, cost-effectiveness, and access to a greater variety of trading opportunities offered by this smart strategy can be greatly beneficial. Synthetic options have a lot of potential, and by utilising them correctly, investors can maximise their profits in a dynamic financial market.

 

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