Options Education - Synthetics

 Options educational content provided courtesy of ChartBender.

Each of the "natural" instruments in the triangle below can be simulated using the two instruments indicated in the corresponding oval. For example, long stock can be simulated, or synthesized, by purchasing a call and simultaneously selling a put short, both at the same strike price. This call-put combo behaves just like long stock, and is therefore called synthetic stock.

The figure below shows all of the synthetic equivalents for each of the natural instruments.

Synthetics are important for two reasons. The first is efficiency. With synthetics, one can consider the combination of options and stock that most efficiently (i.e., economically) creates the desired P&L profile. In consideration of trading commissions, you wouldn't buy a call and short a put if you wanted the risk profile of long stock. You would simply buy the stock. It's one trade versus two.

Being long 100 shares of stock and short 1 call is a synthetic short put (see the synthetics diagram above). The covered call and the short put should therefore produce the same P&L profile. The short put is more cost-effective than the covered call because it's a single trade, while the covered call is two trades: 1) buy the stock and 2) short the call.

Perhaps more important than efficiency is the fact that synthetics open your eyes to powerful trading alternatives. You can create an investment that matches your market outlook and risk tolerance precisely. Indeed, you can control your risk in single-share increments.

Refer to the P&L Profile calculator in the Synthetics section of ChartBender to see how this works for different trade scenarios.

This educational content is provided by ChartBender.
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