Synthetic Option Versus Standard Option

Submitted by: NOble Drakoln

Synthetic options come in one of two flavors, synthetic calls or synthetic puts. They each are designed to simulate a standard call or put option without the drawbacks. A synthetic call is simple to initiate. A long position is first established in a spot forex market, futures market, or stock market; then an at-the-money put is purchased to protect the long position against any downside risk. A synthetic put requires that a short position be initiated first and an at-the-money call is purchased to protect the short position from any sudden moves to the long side. They are one of the most underused risk management tools available.

The two strategies of using options as a hard stop or using options as a hedge are distinct from the synthetic option because of one factor, the use of an at-the-money o

 

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ption. The at-the-money option is an essential component. While it may be more expensive to purchase an at-the-money option, it establishes the necessary maximum protection for the long or short position.

The Greeks and Synthetic Options

When trading a standard option, there is the constant stress of the greeks. The delta assesses how much the value of an option moves in relation to its underlying asset. No matter how successful the option, it will rarely move dollar for dollar with its underlying asset. This is not a problem for synthetic options. Since one side of the synthetic option is the actual asset, delta does not play a factor when the synthetic option moves into-the-money.

The greek value theta measures the time value left in a standard option. Since options have finite time until expiration, the more time you have until they expire the more valuable they can be, regardless of the strike price. As every day gets closer and closer to expiration, the time value erodes and the option decreases in value proportionate to the time it has left. With a synthetic option you can eliminate the time value completely. If one leg of the synthetic option is a share of stock, spot forex contract, or contract for difference (CFD), there are no time limits on when you have to exit or how many times you have to roll the contract over. Therefore, there is no built-in time value to actually lose in the position.

Finally, the third greek component, vega, was created to measure implied volatility. It measures how much an option’s price will increase or decrease depending on an option’s level of demand. Understanding and using vega is great when determining what strike price to purchase for an option. Volatility is everything when it comes to options trading. The lack of volatility in any particular option can be so detrimental as to make even a successful strike price be worthless because no one is interested in purchasing it.

Vega does not have an impact on synthetic options. There is no secondary market of volatility that has to be monitored or followed. If the market is moving up, your synthetic long position is gaining in value; if the market is moving down, your synthetic short position is gaining in value.

Delta, theta, and vega are just a few of the greeks that have an impact on option pricing. There are other greeks that are also followed religiously by traders who buy and sell options. None of these greek calculations directly apply to a synthetic option position. In fact, any attempt to follow the greeks for a synthetic option most likely is a waste of time.




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About the Author: Noble DraKoln is founder of Speculator Academy, http://www.speculatoracademy.com/. After becoming a licensed broker at the age of nineteen, he has gone on to author seven trading books. He is also the author of the books Trade Like a Pro, Winning the Trading Game, published by Wiley and Sons.

Source: www.isnare.com