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Option SyntheticsOption Synthetics: The Building Blocks of

Options Strategies

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Required Reading

For the sake of simplicity, the examples that follow do not take into consideration commissions and other transaction fees, tax considerations, or margin requirements, which are factors that may significantly affect the economic consequences of a given strategy. An investor should review transaction costs, margin requirements and tax considerations with a broker and tax advisor before entering into any options strategy.

Options involve risk and are not suitable for everyone. Prior to buying or selling an option, a person must receive a copy of CHARACTERISTICS AND RISKS OF STANDARDIZED OPTIONS. Copies have been provided for you today and may be obtained from your broker, one of the exchanges or The Options Clearing Corporation. A prospectus, which discusses the role of The Options Clearing Corporation, is also available, without charge, upon request at 1-888-OPTIONS or www.888options.com.

Any strategies discussed, including examples using actual securitiesprice data, are strictly for illustrative and educational purposes and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities.

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Tradeoffs

» Risk and reward must be balanced in all option trades

» The probability of profit and the potential for profit or loss must be considered

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Review

» Options have value for two reasons, potential price change (volatility) and the cost of carry (risk free interest rates and dividends)

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Cost of money

» If an investor bought a $100 stock last year and the stock was trading at $100 today, did the investor lose money?

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Synthetics are the Foundations of Options

» A further understanding of these relationships will enhance overall options knowledge

» Calls can easily be “built” to act like puts and puts can be “built” to act like calls

» Market forces ensure fair pricing for market participants by engaging in options arbitrage

» Three examples are synthetic call, synthetic long put and synthetic short put

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Synthetic Long Call

» Long stock and long put builds a synthetic long call

» The risk/reward balance are nearly identical to plain long calls

» The purchase of the put insures the downside selling price but increases the breakeven amount

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Plain Long Call

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Long Stock

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Long Put

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Long Stock and Long Put

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Synthetic Long Call = Long Stock and Long Put

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Synthetic Long Put

» Short stock and long call builds a synthetic long put

» Risk/reward is nearly identical to plain vanilla long put

» The purchase of a call combined with a short stock position insures the upside buying price but increases the breakeven amount

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Plain Long Put

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Short Stock

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Long Call

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Short Stock Long Call

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Synthetic Long Put = Short Stock and Long Call

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Synthetic Short Put

» A Covered Call, long stock aggregated with a call sold

» The risk/reward is very similar to a short put

» Substantial downside risk with a limited upside potential

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Plain Short Put

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Long Stock

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Sell Call

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Covered Call

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Synthetic Short Put = Covered Call

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Put-Call Parity

» Put = Present value of strike + call – stock

» Early exercise complications must always be considered

» Borrowing and lending rates and dividends are important factors

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Refresher: What is Present Value?

» Money earned today is worth more than money earned next year due to compounding of interest

» Assets have carrying costs; an opportunity cost that is foregone, this carrying cost is vital for options

» Option synthetics include this cost using the present value of the strike price

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Synthetic Equations

Stock + Put = Discounted strike + Call

Stock + Put = Treasury Bill + Call

» Note the strike price is effectively reduced by amount of money that can be earned risk-free

» The amount of the discount is the strike price * risk-free rate * days to expiration/365

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Synthetic Call Relative to “Plain” Call

» Stock is $ 20 and the strike price is 20

» Present value of strike effectively discounts the strike

» Cost of carry (discounted strike) = Principal * Rate * Time (55 days * .05)

» Call is $ 1.15, Put is $1.00

» Using the aforementioned formula, Stock + Put = T-Bill, (discounted strike) + Call

» 20.00 + 1.00 = 19.85 + 1.15

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Additional Complications

» Margin rates

» Commissions

» Taxes

» Changing dividends and interest rates

» Corporate actions

» Exercise and assignment risks

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Cash Flow Examples

» If we were to buy XYZ at $20.00 and buy the XYZ 55 day 20 strike put for $1.00 your cash flow invested would be $21.00 with the ability to sell XYZ at $20 anytime until expiration (the long put)

» If we were to buy XYZ call at $1.15 the remaining proceeds (19.85) can be invested at a risk-free rate that would generate .15 of income or a total cost of $1.00

» The cash flows are identical, the risk and reward tradeoffs are identical

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No Arbitrage Opportunities

» There is very little chance to take advantage of pricing anomalies

» Calls that “appear” more expensive relative to puts are normally not more expensive

» Cost of carry creates these illusions, the higher the price of the stock the greater the cost of carry

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Professional terminology:Conversions and Reversals

» Professionals arbitrage call and puts to keep them at relative value with each other

» Conversion= Buy stock, buy put, sell call

» Reversal= Sell stock, sell put, buy call

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Examples

» Buy stock @$20, buy 55 day put for $1, sell call for ($1.15), what is your carry cost? $20*.05* 55 days/365 calendar days = .15 cost of carry (conversion)

» Sell stock @$20 sell put $1.00, buy call $1.15, what is the carry cost? $20 +$1.00 + carry rebate $.15 –$1.15 for purchased call = 0 (reversal)

» Assumes European exercise (equity options are all American style and therefore have early exercise risk)

» Also assumes stock can be shorted, and borrowing and lending are the same (this is normally not true)

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Risk/Reward is the Key

» Option synthetic relationships give investors insight into the options marketplace

» Put-Call parity allows investors the ability to value puts if they know the call price or vice-versa

» The risk/reward of each trade must be weighed to determine if the trading strategies considered meet your own investment goals

» The probability of profit and the potential for profit or loss must be considered

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ISE Website

» ISEoptions.com- Valuable product, educational information and market data information is available