In my previous article , we covered the construction of a synthetic equivalent for each of the six basic trading positions. Here's a quick review:


Six Basic Trading Positions

Here's a review of how to construct synthetic equivalents
Base Position Synthetic Equivalent Comments on the Synthetic Position
Long stock Long call and short put Generally requires little or no cash to enter, less margin and no borrowings.
Short stock Short call and long put Generally requires little or no cash to enter, less margin and no borrowings.
Long call Long stock and long put A common result of a bull put spread if the stock drops precipitously.
Short call Short stock and short put A very risky position, either in the base configuration or in the synthetic equivalent. It will probably require significant margin to enter, especially if your brokerage house is unsophisticated in option risk.
Long put Short stock and long call A common result of a bull call spread if the stock rises significantly.
Short put Long stock and short call A very common position, also known as a "covered call." As the covered call is simply the equivalent of a short put, the risk inherent in the trade should be obvious.
Source: Optionetics.com

As I pointed out, there are at least five reasons that you might prefer a synthetic position as opposed to the original:

  1. The synthetic position is less costly, either in cash or margin requirements.

  2. Entering the synthetic position reduces commissions as opposed to entering the basic position.

  3. A synthetic position actually improves some element(s) of the base position that you are looking to enter.

  4. The synthetic position will permit easier adjustments to the trade as conditions change.

  5. You may inadvertently end up in a synthetic position as part of your trading activities.

As we expand our investigation into more advanced synthetic trades, the same reasoning will continue. Let's look at synthetic versions of two common trades, a bull call spread and a bear put spread, and analyze why we might prefer the synthetic trade to the original.

The Bull Call Spread

As you know, a bull call spread consists of purchasing a call with a given strike and simultaneously selling a call that expires in the same month with a higher strike than the call you purchased. This is obviously a debit trade (money is taken out of your account), as lower-strike calls are always priced higher than higher-strike calls, given the same expiration month.

Now we need to construct a synthetic bull call spread. Using the table above, we can simply substitute the synthetic version of the two terms in our bull call spread (long a lower-strike call and short a higher-strike call). If we want to use a synthetic in place of our long, lower-strike call, we will simply go long the stock and long a lower-strike put. Similarly, the replacement for our short higher-strike call is to be short the stock and short a higher-strike put.

  • Bull Call Spread = (Long one lower-strike call) + (Short one higher-strike call)
    This becomes:

  • Synthetic Bull Call Spread = (Long 100 shares of stock) + (Long one lower-strike put) + (Short 100 shares of stock) + (Short one higher-strike put)
    Rearranging the terms, we get:

  • Synthetic Bull Call Spread = (Long one lower-strike put) + (Short one higher-strike put) + (Long 100 shares of stock) + (Short 100 shares of stock)
    The "long stock + short stock" terms simply cancel each other out, and we get:

  • Synthetic Bull Call Spread = (Long one lower-strike put) + (Short one higher-strike put)
    In trading terms, this has a name: The bull put spread. Thus, a synthetic bull call spread is simply a bull put spread!

Why might we choose a synthetic bull call spread (bull put spread) over the traditional bull call spread? For one thing, the bull put spread is a credit trade, while the bull call spread is a debit trade. It somehow always seems better to have money coming into my account (a credit) than to have money leaving my account (debit). If there were no difference in price, I'd generally choose the credit trade. In addition, depending on the specific prices of the options at any time, one trade (at given strikes) will generally have a slightly better risk/reward ratio than the other.

A Biotech Example

Using the closing option prices for Aug. 15, the applicable prices for selected options on Chiron ( CHIR), a biotech company trading at $39.01, are shown in the table below.


Pricing the Options
Using closing option prices for Aug. 15, these are the applicable prices for selected options on Chiron
Option Calls Puts
Bid/Ask Bid/Ask
'02 September 35 4.90 / 5.30 0.95 / 1.20
'02 September 45 0.35 / 0.60 6.20 / 6.70
'02 October 35 5.50 / 6.00 1.50 / 1.75
'02 October 45 1.00 / 1.25 6.80 / 7.30
Source: Optionetics.com

As seen in Chiron's chart below, $45 has been a rough average for the past several years. Recently, the stock took a 33% tumble, closing below $30, but has been moving back up.

If we thought its price was going to move back into the $45 range, we might choose to enter a bull call spread. Of course, as we've seen above, the synthetic version of the bull call spread is simply a bull put spread. Let's look at the two cases and see which is better.

The September 35/45 bull call spread (buy the September 35 call and simultaneously sell the September 45 call) would cost (risk) $4.95 ($5.30 - $0.35 = $4.95), giving us a potential profit of $5.05 as long as Chiron closed above $45 on Sept. 20. At the same time, the September 35/45 bull put spread (buy the September 35 put and sell the September 45 put) would generate a $5 credit into our account, meaning that we can make $5 and are risking $5. In this case, the bull call spread has a slightly better potential return than the bull put spread ($5.05 vs. $5).


Bull Call Spread vs. Bull Put Spread
Although the reward/risk ratios are comparable, there are differences
Type Construction Risk (Debit) (3) Reward (Credit) (3)
September Bull Call Spread (1) Buy Sep 35 Call Sell Sep 45 Call $4.95 $5.05
September Bull Put Spread (2) Buy Sep 35 Put Sell Sep 45 Put 5.00 5.00
October Bull Call Spread (1) Buy Oct 35 Call Sell Oct 45 Call 5.00 5.00
October Bull Put Spread (2) Buy Oct 35 Put Sell Oct 45 Put 4.95 5.05
(1) Debit Trade
(2) Credit Trade
(3) (Risk) + (Reward) = (difference in strikes)
SOURCE: Optionetics.com

If we look at the October 35/45 spreads, giving us another month of time for the stock to exceed our $45 target, we see just the opposite: The bull put spread turns out to be slightly more profitable ($5.05 for the bull put spread against only $5 for the bull call spread).

Another factor to consider is commissions. If the stock does indeed close above $45 by expiration day, the bull call spread will generate two more commissions: The trade will have to be closed out as both options are in the money. On the other hand, the bull put spread won't have any additional commissions, as both options will end up out of the money and thus are worthless; we can simply let them expire. Of course, if the stock closes below $45, then at least the short put in the bull put spread will be in the money and will need to be bought back, including commissions, and the short call in the bull call spread will be in the money and have to be bought back to close the position -- one commission for either trade.

Although the risk/reward ratios for the bull call spread and the bull put spread are close, there are in fact differences. Depending on just what the prices are at the time you enter the trade, it will (or should) affect your choice of trades.

The Bear Put Spread

The bear put spread, the standard bearish spread trade, presents a similar situation. The bear put spread is made up of a long put at a given strike and a short put with the same expiration month and a lower strike price. We can create a synthetic bear put spread by simply substituting the synthetic equivalent for the long and short put positions, as shown in the first table above. This would lead to the following:

  • Bear Put Spread = (Long one put at a given strike) + (Short one put at a lower strike)

  • Synthetic Bear Put Spread = (Long one call at a given strike) + (Short one call at a lower strike)

The synthetic bear put spread is also a familiar trade: The bear call spread. If we were bearish on Chiron, we could look at entering either a bear put spread, or its synthetic equivalent, the bear call spread. The major difference, of course, is that the bear put spread is a debit trade (money coming out of our trading account on entry), while the bear call spread is a credit trade (money enters our trading account upon entry). Using the data in the "Pricing the Options" table above, and buying at the ask price and selling at the bid price, we'd have the following results:


Analysis of Bearish Spreads
Using the data in the 'Pricing the Options' table above, and buying at the ask and selling at the bid prices, we'd have these results
Type Construction Risk (Debit) (3) Reward (Credit) (3)
September Bear Put Spread (1) Buy Sep 45 Put Sell Sep 35 Put $5.75 $4.25
September Bear Call Spread (2) Buy Sep 45 Call Sell Sep 35 Call 5.70 4.30
October Bear Put Spread (1) Buy Oct 45 Put Sell Oct 35 Put 5.80 4.20
October Bear Call Spread (2) Buy Oct 45 Call Sell Oct 35 Call 5.75 4.25
(1) Debit Trade
(2) Credit Trade
(3) (Risk) + (Reward) = (difference in strikes)
SOURCE: Optionetics.com

The pricing of the options on this stock on this day happen to work out such that the "synthetic" bear put spread (the bear call spread) is the more profitable trade (less cost, or risk) in both of these cases. It is simply a matter of how the individual options are priced at a given time -- this wouldn't necessarily be true in every case.

As these examples illustrate, the original trade and its synthetic version work out to be almost identical. The difference between the standard and the synthetic trades amounted to only 5 cents in these four cases. We can't predict which trade will necessarily work out the best; we must get actual quotes and calculate both positions. You might say that a nickel difference isn't enough to worry about, but if you were to enter a 10-lot trade (10 spreads), you'd be talking about 1,000 equivalent shares, or $50. This will go a long way toward paying for your commissions, or at least will buy you several lunches at the local hamburger palace.

Thus, the addition of a synthetic version of the basic spreads to our trading arsenal can be helpful. Depending on how the trading floor is pricing the individual options at any given time, either the original or the synthetic trade can be slightly better. You'll have to check all of the option prices to determine which trade is best to enter.

Good trading.
By Andrew Neyens, staff writer and trading strategist at Optionetics.com. Send him email at aneyens@optionetics.com.

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