Updated: 11/01/2023

Master Synthetic Put Options: A Complete Guide on Options Trading

options trading 1
.18 Sep 2023
author avatar image Chad Smith

Table of Contents

Options trading, an integral segment of financial markets across the globe, is a sophisticated tool used by investors to reduce risk and maximise profits. This essay illuminates the mechanics of options trading, with a spotlight focus on synthetic put options. Analysing how synthetic puts work in conjunction with market elements can be instrumental in defining investment strategies, and understanding how to create these financial instruments is critical for any modern trader. This comprehensive guide not only explores the theoretical aspects and calculations of synthetic puts, it also provides practicable steps for implementation and case studies illustrating successful utilization.

Understanding Options Trading

Understanding Options Trading

Options trading is a form of derivative trading where one party, the options holder, has the right – but not the obligation – to buy or sell an underlying asset at a predetermined price within a specific time period. Unlike traditional share trading, options trading involves the purchase or sale of an option contract rather than the ownership of the physical asset itself. This flexibility allows traders the ability to speculate on future market direction or protect their existing portfolio from adverse market movements.

There are two main types of options: ‘call options’ and ‘put options’. A call option gives the holder the right to buy an asset at a specified price within a predetermined period. On the other hand, a put option gives the holder the right to sell an asset at a specified price within a predetermined period. The price at which the underlying asset can be bought or sold is known as the ‘strike price’, and the predetermined time period is the ‘expiry date’.

A Close Look at Synthetic Put Options Strategy

‘Synthetic’ is a term often utilised to describe the grouping of individual financial instruments, fashioned to mimic a single financial instrument’s payoff and performance characteristics. Within the realms of options trading, this frequently involves a strategy of purchasing a security and a corresponding call option simultaneously, creating a position manifesting the traits of a put option.

The devised synthetic put option aims to mirror the risk-reward ratio of a put option, typically using other financial tools―most commonly call options and bonds. Despite the complexity implicated in this strategy, it offers several benefits, including enhanced leverage and many strategic possibilities.

To actively employ a synthetic put options strategy, a trader would engage in buying a call option simultaneously as short-selling the asset underlining. The integral concept of this strategy is the profitable gain from a decrease in the underlying asset’s price, offering protection against potential loss should the asset’s price escalate.

When implementing this strategy, the call option’s strike price and the price at which the underlying asset is short-sold should ideally align with the current market price. Thus, if the asset’s price plunges, the incurred profit from the short-sale compensates the loss from the call option’s reduced value.

In summary, a synthetic put options strategy has the potential to be an influential instrument for seasoned investors, aiming to meet a precise risk-return balance. The complexity of this strategy brings along an allowance for increased flexibility, making it possible to synthetically form put options where actual ones may be inaccessible or seem less attractive due to excessive costs or market limitations.

But amateurs should exercise prudence due to the inherent complexity and heightened risk levels this strategy boasts. It is always wise for traders to understand thoroughly all the nuances of options trading, not to mention other potential strategies, prior to making investment decisions. Those keen to explore this approach should consider seeking professional advice or studying this trading method exhaustively to be well-versed in its potential benefits and inherent risks.

Illustration of options trading with charts and stock market graphics

Exploring Synthetic Put Options

Comprehending Synthetic Put Options

In essence, a synthetic put option is an investment tactic devised to mimic a put option’s risk-reward inclination through possessing the underlying asset and concurrently purchasing an equal amount of at-the-money call options. Utilising this financial method involves obtaining the underlying stock and an amount of call options to match. Known as a ‘synthetic’ due to its simulation of a straightforward long-put option’s payoff, this layered investment technique is indeed multifaceted.

The financial market homes two different options: call options and put options. A call option grants the investor the right to buy an asset at a fixed price before a predetermined expiration date. In contrast, a put option gives the investor the prerogative to sell an asset at a particular price before the expiration date. Distinctively, synthetic puts incorporate elements of both call and put options. They can be advantageous when the investor predicts a drastic market reversal.

How Synthetic Put Function

A synthetic put option is constructed with the explicit aim of replicating the return characteristics of a traditional put. It can be created by buying the underlying stock and simultaneously purchasing an equivalent number of call options. If the stock price subsequently falls, the value of the call option will likewise decrease, counteracting the potential loss from owning the stock. Conversely, if the stock price rises, the cost of the call option will increase, thereby empowering the investor to benefit from the stock’s appreciation.

Application of Synthetic Put Options Strategy

A synthetic put strategy could prove valuable under a variety of market conditions. An investor might turn to a synthetic put when they wish to hedge against potential downside risk without liquidating their position in the underlying stock. Perhaps the investor believes that the stock has potential for future appreciation, but uncertainty in the short term makes them anxious about potential losses.

Another potential scenario where synthetic puts are involved is when an investor is bullish on a specific stock but wants to limit potential losses if the stock’s value declines. The synthetic put could then offer downside protection while maintaining exposure to any upside potential.

Moreover, the Synthetic put strategy is also useful for capitalising on volatility. As the investor has ownership of both the underlying stock and a call option, the strategy pays off with sharp moves in either direction. As a result, those traders who anticipate significant but uncertain price movements may employ synthetic puts to harness such volatility.

Pros and Cons of the Synthetic Put Strategy

Synthetic puts present a compelling opportunity for astute investors, offering dynamic risk management capabilities, particularly for those who have significant long positions in certain shares. They serve as a potent tool, empowering investors with the means to shield against potential downside risk, without compelling them to offload the asset in question.

However, utilising a synthetic put approach does not come without its challenges. It is laced with inherent intricacies, making it a strategy not well suited for novice investors. Misjudging or misunderstanding the associated options could result in hefty losses. Additionally, the success of synthetic puts is largely dependent on accurately forecasting market fluctuations, and thus, might not perform optimally during times of subdued volatility. The call options purchase cost at times makes synthetic puts a more expensive route for asset safety.

All things considered, a meticulously planned synthetic put strategy could prove to be a robust risk-management tool in options trading. Just like any other monetary strategy, comprehending its mechanics and having grounded expectations are critical for its effective implementation. With diligent preparation and thoughtful risk evaluation, synthetic puts could be a valuable facet of a diversified investment portfolio.

Illustration of a person analyzing stock market charts and graphs with a synthetic put options concept in the background

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Creating Synthetic Puts

Comprehending Synthetic Puts within Options Trading

Synthetic put is a strategy that involves acquiring a long position in a share and concurrently purchasing a put option on the same share. The aim of this strategy is to emulate the payoffs of a straightforward put option. In essence, this is an insurance strategy, facilitating an investor with the option to hedge their long position in a share by buying a put option.

Step-by-step Guide to Creating a Synthetic Put

Creating a synthetic put involves a series of steps. Firstly, you need to choose the correct underlying security. The security should be one with which you are familiar and understand its market dynamics. The process wouldn’t be much different from picking a security for regular stock trading.

The next step involves deciding the optimum strike price. The strike price is the price at which the put option can be exercised, and it plays a key role in the profitability of the strategy. Ideally, the strike price of the put option should be close to the current market price of the underlying security. If the market prices fall below the strike price, you can exercise the option and preserve your capital.

The expiration date is also a crucial decision point when creating a synthetic put. The expiration date should be chosen based on market volatility and your investment horizon. While a longer expiration date gives more time for the trade to move in your favour, it also comes with a higher premium. Conversely, a shorter expiration date results in a lower premium but increases the risk of the option expiring before the trade moves in your favour.

Risks and Rewards of Synthetic Put Options

There are potential risks and rewards associated with synthetic puts. The prime benefit is the downside protection it provides to the stock position. If the stock price falls significantly, the put option acts as an insurance and limits the losses.

On the flip side, the biggest risk associated with synthetic puts is the premium paid for the put option. If the stock price doesn’t fall below the strike price before expiration, the premium paid for the put option is a loss. This means you need to be right about the downward movement of the stock price within the chosen timeframe, or you risk losing the premium.

Another aspect to consider is the opportunity cost. While your downside risk is capped, you also limit potential upside gains if the share price rises as you have spent money on the put option. The profitability of a synthetic put is hence also dependent on an accurate forecast of the share price movement.

In summary, synthetic put options function as an invaluable instrument for buffering against potential deficits associated with stock investments. However, the successful utilization of this strategy requires meticulous analysis and calculated preparation. Choices relating to the selection of security, determination of strike price and decision on the expiration date ought to be grounded in robust knowledge and logical deduction. Furthermore, a thorough assessment of potential risks linked to the premium payment and opportunity costs is necessary when considering the hedging advantages.

Illustration of a person analyzing stock charts and graphs.

Implementing Synthetic Put Strategies

Unravelling the Synthetic Put Options Strategy

Termed as a ‘protective call’, a Synthetic Put is an investment plan that emulates the potential gains of a put option. This is accomplished through the purchasing or maintaining a ‘long’ stance on an underlying asset whilst concurrently buying an at-the-money call option for the same asset. This strategy is most commonly used when an investor harbours a short-term pessimistic view on a specific asset but still wishes to uphold a long position in anticipation of likely future price appreciation.

When to Apply Synthetic Put Strategies

There are several scenarios where an investor can apply a Synthetic Put strategy effectively. First, when existing investments in an asset have appreciated significantly, the synthetic put strategy can be employed as a hedge to guard against short-term downside risk while retaining potential future upside. Second, synthetic puts can be employed when high transaction costs make buying puts expensive. Third, during periods of market volatility, the demand and price of put options increase. Instead of buying a put option, investors can implement a synthetic put strategy to control costs.

Potential Pitfalls of Synthetic Put Strategy to Avoid

Implementing a synthetic put strategy brings its potential downsides. Primarily, it introduces the risk from the sale of the call option. In case the market price of the asset falls significantly, the call option would go ‘out-of-the-money’ and incur a loss. Additionally, this strategy is cost-intensive as it requires covering the premium costs of the call options. Hence, understanding the exact timing and conditions to employ this strategy is crucial to making this strategy profitable.

Managing Risk with Synthetic Put Strategy

Synthetic put strategies come with their inherent risks, therefore careful risk management is critical. Monitoring market trends and adjusting the strike price of the call option in response can mitigate the risk to an extent. Moreover, managing positions and having a clear exit strategy can also help to manage potential losses.

Also, hedging the synthetic put position with other option strategies or setting stop limit orders can limit the downside risk. For example, one can complement the synthetic put strategy with a covered call or protected put strategy. The approach to use will depend on the investors’ preferences and market conditions.

Lastly, investors should always remember that the synthetic put strategy should be used judiciously and sparingly, and not as a substitute for sound fundamental investment strategies. It is a risk management tool and not a standalone investment strategy.

Points to Ponder

On considering a synthetic put strategy, don’t overlook transaction costs, potential tax exposure, and the liquidity of the preferred options apart from the risks and possible rewards. It is crucial to carry out a comprehensive examination and analysis of the prevailing market conditions before deciding upon the implementation of a synthetic put strategy.

If you are new to options trading or uncertain regarding any aspects of synthetic put options strategy, it may be wise to seek professional advice. Progressing to a skilled trader demands time, knowledge, and experience, but once you understand the concepts thoroughly, you can undoubtedly utilise options to guard your positions and manage risk successfully.

Illustration of a person juggling different investment concepts to represent the complexity and risk management of synthetic put options strategy

Photo by paipai90 on Unsplash

Case Studies: Synthetic Put Options in Action

Comprehending Synthetic Put Options

Synthetic puts ingeniously replicate the risk-reward profile of a traditional put option through a combination of financial instruments, predominantly selling stocks short and buying call options. This approach presents traders with an opportunity to safeguard their long position in an asset or security. This is done by essentially wagering against the same asset in which they are invested. Should the price of the asset decreases, the loss borne by the long position is counterbalanced by the gain in the synthetic put.

Synthetic Put Strategy: Case Study 1 – The Insurance Company Hedge

An example of a professional successfully using synthetic put options is an insurance company looking to protect its portfolio during economic downturns. When the forecasts anticipate a recession, the company may decide to use a synthetic put to protect against significant portfolio losses.

The company, for instance, has long positions on a large number of assets. To protect these, they decide to use a synthetic put option. They first sell short the same assets they have long positions in, and simultaneously buy a call option for those assets. If the value of their long positions decreases as a result of the economic downturn, the profit made from their short positions coupled with their call options will offset the losses.

Synthetic Put Strategy: Case Study 2 – The Tech Company Investment

A technology company’s investment department emerges as another successful case study. The department may use synthetic put options when the tech sector’s outlook is uncertain, whilst maintaining their investments in technology companies.

For example, if the department maintains significant long positions in tech stocks, but there are indications of a technology bubble burst, the company can create a synthetic put by shorting the same tech stocks and buying call options. If the bubble bursts and stock prices plunge, the losses from the long position will be counterbalanced by the gains from the short position and the call options.

The Effective Use of Synthetic Put Options

Synthetic put options are admittedly complex and require advanced trading knowledge. However, with thorough understanding and careful application, these options can form a vital part of a diversified trading strategy.

Traders and professionals can use these trading strategies to manage risk and protect against potential losses. Utilising synthetic puts is a proactive approach to portfolio management that can provide a safeguard against significant downturns in individual stocks or the broader market.

It’s important to understand though, like any other strategy, synthetic puts are not suitable for all investment objectives and they come with their own set of risks. Therefore, it’s crucial to consult with a knowledgeable financial advisor before implementing these strategies.

Illustration of financial charts and graphs representing the concept of synthetic put options.

Having explored the principles of options trading and drilled down specifically into synthetic puts, it’s clear that this strategy opens up a myriad ways to approach market conditions. Synthetic put strategies prove to be a powerful instrument when understood and employed properly. Highlighted through a series of real-world case studies, their significant roles within profitable trading strategies have been emphasised. Remember, effective trading is not just about knowing the inner workings of different strategies, but also about timing, vigilance and a deep understanding of market forces. The knowledge garnered from this comprehensive exploration of synthetic puts can immensely help you in making more informed trading decisions, reinforcing a robust trading portfolio.

author avatar image
Chad Smith

Chad Smith is the Director of Research & Analysis here at ForexBrokerListing.com. Chad previously served as an Editor for a number of websites related to finance and trading, where he authored a significant number of published articles about trading and the impact of technology in transforming investing as we know it. Overall, Chad is an active fintech and crypto industry researcher with more than 15 years of trading experience, and you can find him teaching his dog how to trade in his free time.