Synthetic option positions, or 'synthetics', are constructed in such a manner as to have the identical risk/reward 'profile' of, what is called, its 'equivalent' position.
Every 'position' has an 'equivalent position'. Market Makers use them all the time in their daily market-making functions. For example, a 'synthetic' Call option has the same profile as a 'regular' Call option (its equivalent) without using any Call options in its construction.
The six basic types of synthetic option positions are:
(1) Long Stock = Long Call + *Corresponding Short Put.
(2) Short Stock = Short Call + *Corresponding Long Put.
(3) Long Call = Long Stock + Long Put.
(4) Short Call = Short Stock + Short Put (also known as 'Covered Put').
(5) Long Put = Short Stock + Long Call.
(6) Short Put = Long Stock + Short Call (also known as 'Covered Call').
* Note: 'Corresponding' means the same strike price and expiration.
Knowing how to construct 'equivalent' positions through the use of 'synthetics' is extremely useful knowledge.
The only reason to put on a synthetic position initially, rather than its equivalent, is to take advantage of what is referred to as option 'skew' or variance from theoretical value.
For instance, one of the measures of option valuation is its 'delta'. Option theory states that the combined delta values of corresponding Put and Call options add up to 100. Therefore, if a particular Call is trading at 60 deltas, its corresponding Put should be trading at 40 deltas. But markets, being what they are, may not always be 'theoretically' correct. What if the Put is available at 38 deltas? That's known as 'skew'. Saving 2 deltas + long stock is the equivalent of buying a 'cheaper' Call. Who isn't interested in saving money?
By far, the most common use of synthetic option positions by astute traders is to 'morph' a position into a completely different position with one, and only one, transaction. Such use of synthetics is extremely efficient. In other words, why reverse a position with two or more transactions when one transaction will accomplish the same results?
'Morphing' is trading at maximum efficiency
Before getting into 'morphing', let's first understand what 'morphing' is not. Morphing is not turning a 'losing' position into a 'winning' position. Morphing is creating an entirely new position with a single stroke. If it takes more than one move, it's not morphing.
Some possible scenarios:
Suppose, for example, a trader is LONG CALLS and desires to reverse the position and become LONG PUTS. He could sell the Calls and buy Puts (two transactions). Or, more efficiently, simply SHORT STOCK (one transaction) accomplishing the same thing.
Our trader could, just as easily, reverse course again simply by buying back the short stock thus, once again, being LONG CALLS.
Can you see how useful this 'synthetic option positions' technique can be? Think of it as an 'on-off' position switch.
A trader is LONG PUTS and desires to switch to being LONG CALLS. Again, the trader could sell the Puts and buy Calls (two transactions) oraccomplish the same thing in one transaction by adding LONG STOCK to the existing position.
Later, our trader could, if desired, switch back to the LONG PUTS position, again in one transaction, simply by selling the LONG STOCK. Wow! How's that for flexibility?
Trader is Long Call. Selling a Call with a higher strike price 'morphs' or 'legs' into a Bullish Call Spread. Buying back the higher strike Call 'morphs' back to a Long Call position.
Trader is Long stock + Long Put (synthetic Call). Selling a higher strike price Call 'morphs' into a 'Collar' (which is also the 'equivalent' of the Bullish Call Spread seen in Scenario #3). Buying back the Call 'morphs' back to the Synthetic Call position.
The usefulness of synthetic option positions for a trader cannot be overstated.
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