Options are touted as one of the most common ways to profit from swings in the market. Whether you are interested in trading futures, currencies or want to buy shares of a corporation, options are considered a low-cost way to make an investment without fully committing. While options have the ability to limit a trader's total investment, options can also open traders up to volatility risk, and increase opportunity costs. Because these serious limitations affect options investing, a synthetic option may be the best choice when making exploratory trades or establishing trading positions.
SEE: Reducing Risk With Options
Thoughts About Options
There is no question that options have the ability to limit investment risk. If an option costs $500, then 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. This safety net comes with a cost, though. According to data collected from 1997 to 1999 by the Chicago Mercantile Exchange, 76.5% of options held until expiration expired worthless. Faced with this glaring statistic, it is difficult for a trader to feel comfortable buying and holding an option for too long.
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 may pay too much for the option or that it may 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 being able to discern what makes one option strike price better than any other option strike price. Once an option strike price is chosen, it is a definitive financial commitment. The trader must assume that the underlying asset will not only achieve the strike price level, but will exceed it in order for a profit to be made. If the wrong strike price is chosen, the entire option investment is lost. This can be quite frustrating, particularly when a trader is right about the market's direction, but picks the wrong strike price.
The World of Synthetic Options
Many of the problems mentioned above can be minimized or eliminated when a trader decides to use a synthetic option instead of simply purchasing an option. A synthetic option is less affected by the problem of options expiring worthless; in fact, the CME statistics can work in a synthetic's favor. Volatility, decay and strike price play a less important role in a synthetic option's ultimate outcome.
When deciding to execute a synthetic option there are two types available: synthetic calls and synthetic puts. Both types of synthetics 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
If the price of corn is at $5.60, and the sentiment of the market has a long side bias, then you have two choices. You can either 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 your risk, but the question then becomes whether $3,000 is a fair price to pay for an at-the-money option. If the market starts to move down, how much of your 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 having outright futures positions, and therefore requires fewer margins. Depending on the market\'s volatility, there can be a margin discount of 50% or more. For this market, there is a $1,000 margin discount. This special margin rate allows traders to put on a long futures contract for only $300. This is just one benefit of putting on a synthetic position.
A protective put can then be purchased for only $2,000. The total cost of the synthetic call position becomes $2,300. Compare this to the $3,000 you would have to pay for a call option alone and there is an immediate savings of $700. In order to get this same type of savings you would have to purchase an out-of-the-money call option.
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, the synthetic positions are able to curb the unlimited risk that a cash or futures position has when traded by itself. A synthetic option essentially has the ability to give traders the best of both worlds, while diminishing some of the pain. While synthetic options have many superior qualities compared to regular options, that doesn't mean that they don't come with their own set of problems.
SEE: Synthetic Options Provide Real Advantages
Disadvantages of Synthetics
The first problem involves the cash or futures position. Because you are holding on to a cash position or futures contract, 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 if you purchase an option at-the-money.
This leads to a second problem: in order to have the best protection, an at-the-money option must be purchased, but at-the-money options are more expensive than out-of-the-money options. This can have an adverse effect on the amount of capital that you may want to commit to a trade.
Thirdly, even with an at-the-money option protecting you against losses, you must have a money management strategy to help you determine when to get out of the cash or futures position. Without a money management strategy to limit the losses of the cash or futures position, an opportunity to switch a losing synthetic position to a profitable option position can be missed.
Finally, if the traded market has little to no activity, the at-the-money protective option can begin to lose value due to time decay. This can force a trader to abandon a trade early. So, while there may not be a need to worry about whether an option can expire worthless, money management rules must be implemented to help minimize unnecessary losses.
The Bottom Line
There is no magic bullet when it comes to trading. It's refreshing to have a way to participate in option trading without having to sift through a lot of information in order to make a trading decision. When done right, synthetic options have the ability to do just that: they can simplify your trading decisions, make your trading less expensive and allow you to manage your trading positions more effectively.