Oh no, more math? Yes, but it's worth it, I promise. And after
all, options attract math geeks, so admit it - you're a little
curious, aren't you?
The kind of algebra I'm talking about lets us create any option
position or underlying position we want out of something else.
Believe it or not, there are some times when this is useful.
Here's the basic equation:
Stock + Put = Call
Using proper math geek notation, we could write this as:
S + P = C
Here's what it means. Say that trader Amy owns some stock worth
$100. She makes money if its price goes up, and she loses if it
goes down. Now suppose that Amy is worried about an upcoming event
that might hurt the stock. For insurance, she buys a protective put
with a strike price of $98. She pays $ 4.00 for the put.
Now, Amy no longer can lose up to $100 on the stock. Her loss is
limited. The put option gives her the right to sell the stock for
$98 no matter what. So her maximum loss on the stock is $2.00, from
the current $100 price down to the $98 strike. Adding to that $2.00
loss the $4.00 that she paid for the put, Amy's worst possible
outcome is a $6.00 reduction in her net worth. Her possible profit
is still unlimited in case the event doesn't hurt the stock. Her
upside profit is reduced, however, by the $4.00 cost of the
insurance. The stock now has to go up in price not just by one
cent, but by four dollars and one cent, for her to make a profit on
it. So her new break-even price is $104.
Hmm. Unlimited upside, limited downside, and a breakeven price
that's higher than the current price. That sounds familiar. Oh
yeah, that sounds just like a long call option.
And it is. Imagine another trader named Bert. Instead of a s
tock-plus-put combo, Bert buys a call at a strike price of 98,
paying $6 for it. What is his P/L situation? Well first, the stock
has to go up for him to make money. Since he paid $6 for the call,
if he keeps it until expiration, the stock would have to rise above
the $98 call strike by that amount. That is, to $104. This is his
break-even price, which is the same as Amy's.
If at option expiration the stock is above $104, Bert's call makes
money, and his upside is unlimited. Just like Amy's.
Bert's worst case loss would occur if his option were worthless at
expiration. That would occur if the stock ended up at the $98 call
strike or anywhere below that. His loss would be his cost for the
call, which is $6 - exactly the same price and maximum loss as Amy.
In fact, up until option expiration,
at any price Bert and Amy's profit or loss would be
. The profit for the stock plus the put, equals the profit of the
long call alone.
In other words, s
tock plus put equals call
: [S + P = C]. By buying a put [+P] , Amy turned her long stock
position [S] into a
[C]. Synthetic in option lingo means "made out of something else."
Things don't just work out this way because I chose the numbers for
this made-up example. These are relationships that must hold in
order for the option market to work. This is a very simplified
description of a principle called
, about which you can read more
Calls are not the only thing that can be created like this, or
. We can make any position out of the other ingredients. All we
have to do is rearrange the algebra.
If [S + P = C], then all of the following also must be true, and
[-S - P = -C] Short Stock plus Short Put = Synthetic Short Call
[C - P = S] Long Call + Short Put = Synthetic Long Stock
[P - C = -S] Long Put + Short Call = Synthetic Short Stock
[C - S = P] Long Call + Short Stock = Synthetic Long Put
[S - C = -P] Long Stock + Short Call = Synthetic Short Put
How can this information be used? Well, first, although each actual
position has the same P&L as its synthetic equivalent, the
amount of capital required will be different. In the example of
Bert and Amy above, Bert's cost was $6, while Amy's was $104. Same
P&L, 17 times the cost.
Secondly, sometimes we can combine a synthetic with something else
we already have to create a composite position that we want. One of
the most common examples is the
. There are a couple of different ways to use a collar. One of them
is as another means of protecting an existing position.
Assume Amy wants another alternative to protect her $100 stock. She
thinks the danger to the stock is short term. After the event,
either the stock will be crushed or it will be fine. She would like
just to freeze her position until after the event passes. She could
create a collar by adding a
synthetic short stock
actual long stock
. Then what she makes or loses on the actual long stock will be
exactly equal and opposite to what happens to the synthetic. The
net effect will be zero.
To accomplish this, Amy checks the table above and sees that [P - C
= -S]. Long Put + Short Call = Synthetic Short Stock. She needs a
short call and a long put, both at the $100 strike price. The short
call is no problem - since she owns the stock, the call is covered.
She doesn't need to put up any additional capital to secure the
call. In fact, the call will probably bring in nearly the same
amount of cash that she needs to buy the put. The collar is a
no-cost insurance policy. (There is a tradeoff though - although
Amy now can not lose, she can not gain anything either. The meter
only starts running again once she removes the collar).
Editor's note: This story by Russ Allen originally appeared on
Online Trading Academy
To read more from Online Trading Academy, see:
The Nerve to Win
Risk Management Basics
Program Trading and the Markets