SYNTHETIC OPTIONS

[TradingAdmin]

I have a user who posted two questions:

• Please explain with examples how to use Synthetic Options
• Please explain with examples how a Calendar Spread works

I will address these in two separate discussion topics - please feel free to participate.

Herewith the Synthetic Option...

[TradingAdmin]

A SYNTHETIC OPTION, if used correctly, is a very handy tool to have in your arsenal.  It simply says - instead of setting up the option (Long or Short; Call or Put) directly by buying / selling the option - we setup the exact same position using the opposite option in combination with a Futures.

Therefore instead of Buying a Put, we Buy a Call (the opposite) and then Short the Futures.  Or instead of Shorting a Put, we Short a Call (opposite) and then Long the Futures.

Before I show it to you..- WHY IN THE WORLD WOULD I WANT TO DO THAT !?
In essence, we are reversing direction without getting out of the market!  If I am long a futures and then go short a futures, the two cancels each other out and I am out of the market.  However if I am Long a Call option and go short the futures, the Call becomes a Put - I am now long a Put.  Where before I profited when prices went up, I am now profiting when prices goes down!  I have reversed my position in the market!

WHEN DO WE WANT TO DO THAT?

• I do it frequently trading for example Crude Oil intraday on a 15 minutes chart.  Crude can very quickly switch direction.  It really likes to make large moves in a direction and then late afternoon reverse direction.  I like to ride it in the one direction using an ATM option (maybe slightly OTM, like a 0.45 delta), then when it reverses direction - on a 1-2-3 on a 15 minute chart, or after a reversal bar, I trade directly in the futures to also switch direction.  For example I buy a 55.5 Put when the market trades at 55.9.  the market drops to 54.5 - I have roughly $500 profit at this point.  It now looks like it wants to reverse, so I Long a Futures.  The market goes back up to 55.0.  I take $500 on my long futures and $225 on my long Put.  If I am wrong, I am very quick to get out of the futures again and then take profit on the Put.
• It works well for a level market, where it whips up-and-down-and-up-and-down!  When at the bottom you buy a call, when at the top you short the futures, swapping to a long put, at the bottom you buy out of the futures again you are back into a long call.  This way you ride the market all the way - as it goes up and down, you ride it up and down as well.  Note this is if the IV is low.  With a high IV, you Short a Put when it is at the bottom of the range, when at the top of the range you Short the Futures (swapping to a Short Call) etc.
• It works well if we are not 100% certain of market direction - or we want to attempt to get in early - not waiting for an actual signal - thus we get in into one direction and then be prepared to immediately switch direction if we are wrong about the market!For example the market made an extraordinary long bar down - you know typically after such a move it tends to correct back up, so you buy a call (or short a put) then enter an order to short the futures directly below the low of the long bar - in other words if you are wrong and the downwards move continues, you switch direction on your option, giving you a chance to get out with a small loss, or maybe even a profit.  If you were right, your futures order would never have triggered and you will make good money on the correction!
• I also use it to setup trading strategies, for it gives me more control.  Say I would like to short strangle the market (neutral market) - which is selling a call above the market and selling a put below.  The market is at the top of the range.  Instead of selling a Put and a Call; I Short 2 x Calls and Long the Futures (the one short Call is the [Short Call] part of my trade.  The other Short Call combined with a Long Futures is a Synthetic Short Put and forms the [Short Put] part of my trade.  INSTEAD though:  I Short the two Calls and then enter the Long Futures as a stop order above my market range.  If the market immediately drops, I make profit on two Short Calls, I am a happy trader.  If the market instead trades up, my Long Futures will trigger converting into the strangle !!

Once you have mastered the technique, you will find there are many more strategies where you may employ this principle - it is a VERY HANDY tool!!  (But that said, it is an advanced topic - you have to really understand about long and short and calls, puts and futures combinations)

[TradingAdmin]

HOW TO SET IT UP?

Think about the Delta! 

• A Long Futures is +1
• A Short Futures is -1

Now combine that with the delta on your option to swap from a positive delta to a negative delta, or vice versa from a negative delta to a positive delta!!

Therefore:

• A LONG CALL (positive delta, less than 1) combined with [ -1 ] (short futures) will give you a negative delta!  Long Call at 0.4 delta, PLUS Short Futures at -1 delta = 0.4 - 1 = -0.6  The OTM Long Call became an ITM Long Put
• A LONG PUT (negative delta, larger than -1) combined with [ +1 ] (long futures) will give you a positive delta!  Long Put at -0.6 delta, PLUS Long Futures at +1 delta = -0.6 + 1 = 0.4  The ITM Long Put became an OTM Long Call
• A SHORT CALL (negative delta, larger than -1) combined with [ +1 ] (long futures) will give a positive delta!  Short Call at -0.45 delta, PLUS Long Futures at +1 delta = -0.45 + 1 = 0.55  The Short Call became a Short Put
• A SHORT PUT (positive delta, smaller than 1) combined with [ -1 ] (short futures) will give a negative delta!  Short Put at 0.55 delta, PLUS Short Futures at -1 delta = 0.55 - 1 = -0.45  The Short Put became a Short Call

WARNING:  Be careful if your delta's are very small !!  A 0.1 delta will become -0.9 : you go from FOTM to DITM!  Where your risk exposure was 10%, it is now 90% !!  It may be better to stick to 0.4 - 0.6 delta options to limit the risk when you switch!!

[TradingAdmin]

Let us look at this graphically. 

Here is a Long Call OTM on Wheat.  Call 525 Strike, Wheat is trading at 517.25.  Delta is 0.42


Now instead we Long the 525 Strike PUT, then we LONG the FUTURES:


There is ZERO DIFFERENCE between these two positions.  They are setup entirely differently - the one is a long call, the other is a combination long put long futures, but the resulting position is 100% exactly the same!

[TradingAdmin]

Here is a Trade Example. 



Wheat has made a clear 1-2-3 high on a daily chart and yesterday's price bar took out the low of the last up bar (the bar that defined the #3 point).  This is a TTE entry point.  IV is low.  We want to be short Wheat and decide to buy a put option (510 strike price, 0.4 delta)



Here is the position a couple days later..  I don't like this at all, Wheat went down for our entry day only, then immediately corrected.  It has now taken out the #2 point, but immediately formed a reversal bar (new low, but bar closing opposite direction), which is usually a strong signal of a reversal in prices.  I am worried about my position and enter a stop order to long the Wheat Futures one tick above the high of yesterday's price bar. 



Remember this is a buy-stop order, I don't buy the futures yet, I have a resting order to long the futures if the price moves up.  If the price does not move up, I stay with my long put, which is slightly in the money ($68 to be exact).  If prices does move up, my order will execute and my long put will convert into a Synthetic Long Call - I would have effectively reversed my position in the market.



This is exactly what happened!  As prices traded back up, my stop order executed and I went long wheat at 513.8.  My long put converted into a synthetic long call.  At this point in time I am sitting on $692 profit!!

The "synthetic option" allowed me to reverse direction, save my trade and went from a possible losing position into a winning position.


It is not in everyone's nature though to reverse direction - I had to first admit that I was wrong and reverse my opinion of the market !!

[TradingAdmin]

And here a more recent case:



Natural Gas on Friday made an extra-ordinary long move down.  Yesterday it opened slightly higher.  So you could Long a Call option, 0.4 delta (NG trading at low IV) and entered a stop-order to short NG one tick below Friday's close.  The short stop-order will convert the position to a synthetic long put if prices drop.

Today's move saw you making $1350 profit per contract!!  The short stop-order were never necessary!