Understanding Synthetics

Despite sounding somewhat complex, a synthetic option strategy simply refers to combining an option contract with the underlying security to arrive at the same risk/reward profile of a specific options only position.

It is not always the intention of the investor to implement a synthetic position. More often then not, the synthetic is a direct result of some sort of an adjustment to an already existing position.

Reasons may include:

• Risk management
• Cash flow
• Change in directional bias

When considering the use of a synthetic over its options only counterpart, the investor must consider the additional cost associated, including the underlying shares of the security.

Before we do a comparative analysis with a real market example, below is a chart of some common option strategies and their synthetic alternative.

Let’s assume an investor is bullish on Agrium (TSX:AGU) and believes the shares will advance higher over the next year. If the objective is to benefit from an appreciation in share value with a limited risk exposure there are two ways this can be accomplished using options.

With the shares trading close to $94.00, the investor could purchase 500 shares for a total capital allocation of $47,000.00. If the objective is to limit the risk for the next year, 5 January 2015 protective puts at the 94 strike could be purchased for approximately $11.75. This would be a total of $5875.00(this does not include commissions).

The maximum risk exposure to the investor has been reduced to the cost of the puts until expiration. This is approximately 12.5%. This is assuming that the stock is purchased at $94.00 and a 94 strike put is being used as protection. In order to break even, the shares must be trading above the stocks purchase price plus the cost of the put. In this example, the investor would be sitting at a net loss if the stock is below $105.75 on expiration. This is because the put will have expired worthless and the stock has not risen high enough to compensate for its cost.

In comparison, a like minded investor could use a call option as a stock replacement strategy. A January 2015, 94 strike call would cost approximately $11.30. To mimic a 500 share position, 5 call contracts would be purchased for a total of $5650.00 (this does not include commissions). This represents the maximum risk to the investor over the next year…approximately 12% of the underlying share value.

Like the protective put example, the stock must be trading above a specific break even point upon expiration of the calls or else the investor will incur a loss. Because the call option premium was comprised of all time value initially, the shares must be trading high enough to compensate for the time depreciation. As a result, the stock must be trading above $105.30 (the 94 call strike plus the $11.30 premium).

To compare the two strategies, both the protective put and the call option have a risk limited to 12 to12.5% of the underlying share value until January 2015. The break even point on expiration for both approaches fall between $105.30 to $105.75 per share. In addition, both strategies offer an unlimited profit potential.

The benefit to the call option buyer is that the cost to participate in the share appreciation is limited to the cost of 5 calls which is $5650.00. The protective put requires the purchase of the 500 shares at $94.00 for a total of $47,000.00 plus the cost of the 5 puts. This adds an additional $5650.00 for a total capital outlay of $52,875.00. The call position clearly offers the investor the benefit of participating with significantly less capital.

On the other hand, the share holder has the benefit of collecting dividends throughout the year. In addition, if the shares do not trade above the break even on expiration, the investor may continue to hold the position accepting the loss on the put protection, but continuing to hold the stock for future gain. The call buyer accepts the maximum realized loss and must consider the merits of re-entering the trade.

The bottom line is that in both strategies, there is a limited risk exposure capped at the cost of the option with an unlimited profit potential as the share value trades beyond the break even point. This limited risk and unlimited profit potential is only valid until the expiration of the option contracts in both cases. As a result we can make the observation that a long call option is synthetically a long stock position with a protective put. The investor must determine if the benefits of one out weigh the limitations of the other based on their own objectives.