Structuring Synthetics! | OptionsANIMAL
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Structuring Synthetics!

There are no limits to the things you can do with options. Many people are already familiar with the use of options for hedging risk and increasing leverage. Today, I want to talk about the use of options for simulating trades that usually require equity ownership and therefore demand a large use of capital. A thorough understanding of options and their characteristics can allow you to design trade structures that yield most of the benefits of stock ownership without having to own the underlying stock. For the purpose of this article, I am going to ignore the effects of the bid-ask spread, interest rates and dividends, in order to simplify the explanation. In reality, these things do matter, but if you apply these concepts to a highly liquid equity that does not pay a large dividend, they should not matter much.

A synthetic position recreates the risk/reward profile of one trade structure using different instruments. An example that may be familiar to many readers is that of a covered call and a naked put with the options placed at the same strikes. Micron Technology (MU) is currently trading at $33.73. I can buy the stock and sell the December strike 35 call for $1.13. My cost basis and my risk, is now $32.60 and my maximum profit is the difference between the cost basis and the strike of the call, or, $2.40. Alternately, I could sell a naked short put on MU at strike 35 for $2.38. My maximum profit is the credit of $2.38, and my risk is the strike minus the credit – in this case, $32.62. Theoretically, this is true for any strike in any month. The risk and reward of the covered call is the same as the risk and reward of the naked put at the same strike. In reality, the numbers may differ somewhat as you can from the example, based on the bid-ask spread, the interest rate or the existence of dividends.

In order to create synthetics for other trade structures, you can use a simple equation derived from the example we just discussed. Don’t worry, you won’t need too much math. For these equations, we will use the following symbols:
Long Stock = S
Long Put = P
Long Call = C

For a short call, short put or short stock, we will just add the (-) symbol so:
Short stock = -S
Short Put = -P
Short Call = -C

We have already shown that a covered call = a short put. We can use the symbols to write it as:
S + (-C) = -P, or, S – C = -P.

We can simplify this further with a little basic algebra by adding C to both sides, giving us:
S= -P + C.

In English, this means that a long stock is equivalent to a short put plus a long call. This makes sense if you think about the risk/reward profile of long stock. The risk is its cost basis, and the potential reward is unlimited. In the synthetic version, the long call provides the unlimited upside, and the short put provides the risk from the strike price of the put (minus the credit if any) down to zero. By using that one simple equation (S = -P +C), and a little algebra, you can derive the synthetic for just about any trade you wish.

Ok, so what is all this esoteric theory good for? You can use it to replace trades that usually require the significant capital requirement of owning the underlying equity with trades consisting entirely of options. The married put provides a simple example. A married put is a strategy consisting of long equity protected by a long put. The long put increases the cost basis, but dramatically lowers the risk and leaves the unlimited potential upside intact. We can achieve the same risk/reward ratio by replacing the married put with its synthetic equivalent.

We can rearrange the basic equation,
S = -P + C to read S + P = C.

In other words, a married put is the synthetic equivalent of a long call at the same strike as the protective put. At the time I write this; Facebook (FB) is trading at $75. A married put using a December strike 75 long put would increase the cost basis of the trade to 78.09 and reduce the risk in the trade to $3.09. A December strike 75 call is selling for $3.15, providing a similar upside potential reward and a similar risk. There is a slight difference which is probably attributable to differences in the bid-ask spread.

Let’s look at another options trading staple, the standard collar trade. A standard collar involves owning an equity, selling a covered call and buying a protective put where both options expire in the same month. The put reduces the risk in equity ownership. The covered call helps offset the cost of the put, but caps the upside potential of the trade. Using FB again, you can buy the equity for $75. To limit the risk of this position, you can buy a December long put at strike 72.50 for $1.98. You can sell a call at strike 77.50 for $2.02. Your cost basis is now 74.96. For simplicity, let’s just call it unchanged, at $75. The risk is now only $2.50 – the difference between the strike of the put and the cost basis. The upside is capped at a potential profit of $2.50 – the difference between the cost basis and the strike of the short call. However, despite the fact that the risk is far less than the risk of owning unprotected equity, the margin requirement is still the full cost of the equity in a cash account and 50% in a margin account. In other words, the risk is small but the necessary allocated capital is large. This is capital you cannot use for other trades or investments. Moreover, if you have to borrow the equity on margin, you have to pay margin interest, which is often quite high.

Instead, we can structure a synthetic equivalent that uses only options and has no underlying equity requirement. The collar is a married put (P + S) and a short call (-C). We already know that the married put is equivalent to a long call at the same strike. If we replace the married put segment of the collar with its equivalent long call, we end up with a long call at a lower strike and a short call at a higher strike. In other words, a vertical bull call spread. Specifically, we could replace the collar in the previous paragraph with a bull call with a long call at strike 72.5 and a short call at strike 77.50 for the same potential risk and reward but with a far lower capital requirement.

Alternatively, we could replace the covered call portion of the collar (S – C). In fact, we already discovered that a covered call is a synthetic of the naked short put. Replacing S – C with –P turns our collar into a bull put spread. We have a long put at strike 72.50 and a short put at strike 77.50, giving the same risk/reward profile as the collar and the bull call. In short the standard collar, the bull put, and the bull call spreads are all synthetics of one another. Because of different bid-ask spreads on either side of the chain and the possible existence of dividends, these trades may not provide identical risk/reward profiles. You can do the math to determine which structure best suits your needs.

This is not to say that there is no reason to own equities, or that is always better to use a synthetic equivalent. If the underlying equity pays a dividend, you will lose the benefit of it by substituting an options only structure. The standard collar may make more sense if you are adding it to an equity that you have owned for a while and want to protect. Further, equities do not expire, making many potential adjustments more straightforward. However, knowledge of the synthetics can expend your repertoire and make some types of trades more accessible with less capital required.

Jodie Lane
OptionsANIMAL Instructor

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I am sold for life. Keep up the great work everyone.
Thank you,
Steven Hollosi
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By far the best I have found for indepth training and insight as how Options really work. Logical class order. Highly knowledgeable instructors for each element whom can provide detailed answers to any questions.
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The knowledge I've gained from being involved with Options Animal since 2013 has been extremely refreshing & tremendously helpful. I don't have to fret about what's going to happen with any trades I have going, because I already know what can happen in any type of market movement and thus, can prepare accordingly. If you have intentions of becoming a trader yourself, whether you're a rookie or have played with the stock market for years, this is the place you want to be to get you aimed in the right direction. The instructors are amazing - very knowledgeable & deeply caring. The membership community is wonderful. Getting with these people personally at the Summits is a great thing. You most-likely will end up with some wonderful friendships with fellow traders (and instructors) in the community. The things you can do with this education are limited only by you. Scott Hartman - OA Graduate
James Diehl
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My wife and I have tried other on line trading academies and were not impressed with them at all. We became very frustrated to the point of almost giving up the idea of ever being able to learn how to trade options. We heard about Option Animal and decided to give it one more try and we are glad that we did. We were immediately impressed with the entire program. The lessons, both live and archived, are easy to follow and very well done making it simple for even the most novice trader to understand. The instructors are extremely knowledgeable and offer personalized attention when needed. We highly recommend Option Animal if you are serious about learning how to trade options.
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22:16 04 Mar 20
Some classes are very technical, I can repeat them as needed. I would rather retake a class than see it dumbed down.
john kraus
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The experience and information have been outstanding thus far. I insist on thorough coverage when it comes to my interests and pursuits. OptionsAnimal are meeting and exceeding my expectations. The personel are very supportive as well. So far, i have interacted with Brice, Jordan and Warren. All of them were flawless in their professionalism and very personable as well. i never felt rushed in my inquiries and they efficiently offered complete and even comprehensive answers, making sure i understood what i was trying to learn. Thank you!! so far so good!John Kraus
Howie Agster
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19:14 21 May 19
Webinars have great examples of a superb strategy trading options. First in money management and trade adjustments limiting losses. My choice for learning from the best.
Thom Ianniccari
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18:07 29 Oct 17
Great education and support to learn to earn. I have done a lot of investing education and this is one of the few systems that gets a gold star.
Douglas Weed
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22:45 23 Oct 18
Zack quickly answered the question I had about choices for brokerages with respect to commissions.
Bruce Ash
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21:22 01 Jan 19
OptionsAnimal has been a great experience. I have learned a lot about options. It is nice that you can learn at your own pace and get help as needed.
Sunil Tomar
Sunil Tomar
19:05 29 Sep 18
Stephen Sorrick
Stephen Sorrick
20:36 29 Sep 18
The presentations were all highly informative.
Linda Wood
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18:20 04 May 19
Brian Hores
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13:59 11 Jun 19
A well structured curriculum to master the intricacies of options trading. Archived sessions allow you to go at your own pace and review areas of weakness. Live classes with instructors are interactive with a chance to ask questions. The teachers are great with helping to clarify issues and help you succeed. Following he Options Animal 6-step process will lead to trading success. The tuition is worthwhile compared to paying the school of hard knocks. I haven't mastered everything but am a much more confident and profitable trader.
John Daggerhart
John Daggerhart
19:30 24 Nov 18
Very straight forward solid education. No get rich quick B.S. Learn, follow, prosper!
Merlin Andrews
Merlin Andrews
16:01 06 May 19
The best options trading education available that I have ever encountered by far, and one of the best values in any education. Great instructors, a very supportive community, and a tremendous amount of information and content. Not get-rich-quick, but life changing if you are willing to put in the work.As a graduate of the program, I continue to learn and grow from everything provided by OptionsAnimal and continue to improve.
oliver fox
oliver fox
18:43 06 May 19
I am simply amazed at the amount of knowledged displayed by the option animal instructors at the Chicago summit.after having listen , and asking questions ,my knowledge of the stock market,and option has increased to a level way beyond that of the average trader. I am so thankful for finding optionsanimal.
Edith Falls
Edith Falls
18:48 10 Dec 18
Kevin McDermott
Kevin McDermott
20:02 23 May 19
Even though I have been trading options for a couple of years, I was happily surprised by learning things I either did not know or did not understand as well as I should have.Excellent education program that is good for everybody from beginners to experienced options traders. Plenty of resources and actual people who can answer your questions or help you deal with any unexpected difficulties.Top notch organization doing top notch work. Check them out.
Jim Hores
Jim Hores
19:54 10 Jun 19
I found this to be an outstanding program - in-depth knowledge you cannot find anywhere else and the staff is always very supportive. I give it an A++.
Peter Schulz
Peter Schulz
16:08 05 Jun 20
This company is for real! The education is top-notch and can help you whether a beginner or a seasoned veteran looking for new approaches. If you are looking for the resources you need to add options trading to your investing, I can't imagine a better place to get it. The community is amazing and supportive, the instructors are great, and the site has endless archives to go through. Following along with experienced traders as they identify, make, and then adjust trades really drives the lessons home. I wish I had joined this 10 years ago.
Trask Messinger
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12:57 05 May 19
thank you - very professional and informative Summit
DiVerge Fitness
DiVerge Fitness
17:35 22 Dec 18
Great service for learning the correct way to trade options.
Markus Bandomir
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14:53 18 Jan 18
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18:13 15 Jul 19
BRUCE BAILEY
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This was my first Summit experience and I thought attending was very worthwhile. The programs and materials were helpful and the open session Q&A following the presentations was great. I left with six other OA members contact information to really get into the “community” feeling!
Jackson Simon
Jackson Simon
19:58 25 Oct 18
Wonderful experience so far with this superior source of education on options trading. I continue to enhance my skills and knowledge week to week with the help of their highly experienced coaches and easy to follow curriculum. Learn to protect your investments now to ensure a brighter future in retirement and to pass on to your posterity. Highly recommended!
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