TRADING OPTIONS
Think Synthetically, Trade Globally
Synthetically Speaking
by Paul J. Kluskowski
How do you transform your premium from debit to credit? Think synthetic
positions.
Ask anyone in the know and they will
tell you that the risk/reward profile of a long option is limited risk
with unlimited reward potential. The built-in assumption is that the premium
is at risk. What if there was a way to change this? What if the premium
could be transformed from debit to credit, leaving you with a risk/reward
spectrum that was small gain to unlimited gain, versus small loss to unlimited
gain? Impossible, you say? If you can think synthetically, this transformation
is quite possible.
WHAT ARE SYNTHETIC POSITIONS?
Synthetic positions are combinations of stock or futures and options
that give the risk/reward profile of a different tradable. Using synthetic
positions gives us nearly limitless possible combinations, but our focus
right now is to create a synthetic long call option for a credit. A long
call option can be synthetically replicated with the use of a long stock
position with a long put. (I should note here that there is limited downside
risk with hypothetically unlimited upside reward.)
The interesting part comes when you put this on for a credit. Quite
simply, you must "leg" into this position by going long the stock or future
in an uptrend. Once some profit is built in, you can purchase a put option
with a strike price that ensures a small profit, even if you must exercise
the put. A simple stock example works like this:
1. Buy XYZ stock at 15.
2. Let XYZ move to 20.
3. Buy XYZ put with a strike of 17.5 for $2 or less.
You now have a synthetic long call that was created for a credit. No matter
what happens, you will have at least a small profit.
While this works with stock, it is even more applicable in the futures
markets due to the much lower margin requirements to open the initial position.
THE FIRST LEG: FUTURES
Let's use a real-life example with soybeans as the underlying instrument
(Figure 1). On February 22, 2005, July delivery contracts had a price range
of just under $5.700 per bushel to just over $5.900. For the first leg
of the synthetic option, say you went long one July 2005 contract at $5.900,
near the day's high. That was a breakout day for soybeans, so it's conceivable
you would be willing to go long on that day.
As time goes by, you can see the bean contract shown in Figure 1 would
have treated you well. This, then, would have been the first leg.
FIGURE 1: A LONG CALL. Since February 22, 2005, was
a breakout day, you decided to go long one July 2005 soybean contract.
You can see that things did go your way.
...Continued in the May issue of Technical Analysis of STOCKS &
COMMODITIES
Excerpted from an article originally published in the May 2006 issue
of Technical Analysis of STOCKS & COMMODITIES magazine. All rights
reserved. © Copyright 2006, Technical Analysis, Inc.
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