As an option mentor, one of the most common questions I get is “do I really need to know synthetic’s to trade options?” My answer is usually as follows “No, you don’t; however, by understanding these concepts your odds of success are greatly improved.” While I have already explained a few of the most complex reasons that synthetics are important, I thought I might give you a less complex reason why a retail trader should memorize: Call-Put=Underlying-Strike+ (Cost of Carry).
The following is a true story:
I was recently reviewing a potential trade in a stock. For simplicity, we will call this stock XYZ. Stock XYZ was a high quality company trading at the lower end of its 52 week range, at around 59 dollars. The implied volatility of the options was elevated across the board. Based on this information, I decided I wanted to get bullish, sell the 60 strike while tying up as little capital as possible. Immediately I looked at the 57.5-60 call spread. I liked the call spread because it was long delta, short vega, and long theta. The recipe I was looking for. This spread could be purchased for 1.51.
Most traders would simply press that ‘buy button’ at this point. However, rather than jump the gun, I used synthetics. A long call spread is ‘synthetically’ the same thing as a short put spread (a spread where I would sell the 60 put and buy the 57.5 put). Anytime I am going to buy a call spread or sell a put spread, I always see what the value of the corresponding spread might be. I can sometimes find value.
To do this conversion I simply take the difference in strikes and subtract the price of the call spread or put spread I am trading. Basically, the absolute value of the call spread and put spread should always add up to the net difference in between the strikes. If it does not, there could be a spread that is over/under priced.
In the case of stock XYZ there was 2.5 points in between strikes. I could buy the call spread for 1.51, this equated to .99 in the put spread (1.51 + .99=2.50). However, when I looked at the put spread I noticed that I could sell the put spread at 1.02, a full .03 better than the call spread. This does not sound like much, but think about this: on many trading platforms, by selling the put spread vs. buying the call spread, it would not take very many spreads to cover the cost of my commission both in and out of the spread.
If a trader saves him or herself an average of .03 on one 10 lot trade 3 times a week over a year this equates to saving of 4680.00. That enough to buy more than 2 1995 Chevy Berettas (assuming they have about 150k miles), or more than 140 Lobster Lover’s Dream’s (available now during Red Lobster’s Lobster Fest). Or, if you insist, to put back into option trading to potentially put toward other profitable trades.