How to Create Synthetic SPX Equity Positions Using Options

NEW YORK (TheStreet) -- For most equity traders, the S&P and/or the Dow are watched quite closely. While these indices are usually just as important to option traders, the volatility index is generally closely monitored as well. There are a variety of volatility indices to watch, but most traders look at the S&P volatility index, which is commonly referred to as "The VIX."

I spend a lot of time watching the S&P E-mini's as well as watching the VIX. Recently I have been using a variation of what most option traders call synthetic stock positions. Through the use of options, a competent trader can sustain similar returns with far less capital than what would be required to own the stock outright, even if the equity trader was using a margin account.

The traditional structure of a synthetic long stock position involves buying a call and selling a put at the same strike price and expiration date. If an option trader is leaning long, he/she would buy a call and sell the put; likewise, if the option trader is leaning short then the put is purchased and the call is sold. Typically, the trade utilizes options that are near-the-money or slightly in-the money.

For those who remember high school algebra, the mathematical expression of this relationship is S=C-P. The variables are defined as S=stock, C=call and P=put. Using tenth-grade algebraic rearrangements of this equation, the various equivalency relationships can easily be determined.

Before I go any further, naysayers will point out that selling a naked call offers unlimited risk to an option trader as stocks theoretically can rise to infinity. It is true, the naked call position is extremely risky and a naked put position carries significant risk as well, but alas, there are ways to mitigate that risk. So before you start crying about how much risk a trade like this is undertaking, please continue reading.

Before we begin detailed discussions, remember that the risk of option positions is appropriately gauged against the yardstick of equivalent equity positions. Many traders have made the logical error of considering option positions constructed with the same capital against what they think is the same equity position. This is a fundamental error in logic. The appropriate yardstick by which risk is gauged is delta equivalent positions.

For many who are beginning to trade options or those who do not have enough capital, option brokers will not allow option traders to sell naked calls or puts. There is a way around this little issue; the answer lies within a credit spread, which will mitigate the risk of selling a call or put naked. A credit spread is an option strategy where a trader sells a call or put, and then purchases a call or put that expires the same month/week that is further out of the money. The difference represents a credit to the traders account and the maximum gain they can achieve on the position.