UNDERSTANDING SYNTHETIC EQUIVALENCE

How to Make
Calls Into Puts

C OPYRIGHT 2012, O PTIONPIT . COM

iBooks Author
C HAPTER 1

How to Make
Calls Into
Puts

Or...
There is no such thing as a credit spread

www.optionpit.com

iBooks Author
How to Make Calls Into Puts

2012 OptionPit.com. All Rights Reserved.

Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risk of Standardized
Options (PDF). Copies of this document are available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation, One North Wacker Drive,
Suite 500, Chicago, Illinois 60606.
ii

iBooks Author
S ECTION 1 One of the first things professional option floor traders (when
there were professional floor option traders) learn to quote
Introduction was a Buy Write/Synthetic. I can still hear the craggy floor
broker voice, Ok guys, I need the AAPL DEC 350 buy write/
synthetic put market, and I need 2000 up please.

That little hint of 2,000 contracts, by definition 200,000

shares of common, means this was not a typical order. We
would dutifully give our market $1 bid at $1.5, two grand up
and see what would come next. Then the broker would ask,
I N THIS SECTION : what comes at $1.75.
1. Using puts to make calls and stock to make The floor brokers are always peddling their paper. Their job,
options. of course, is trying to get customers filled. It always gives me
2. Understanding risk profiles pause when a market is quoted and the broker wants to lift
right through the offer to fill it. That means they want to get
3. How Synthetic Options help you understand it done and done in a hurry. Like sheep, we would fill the or-
your trades der for 5,000 synthetics and start selling stock as soon as we
could.

There was a lot going on in that transaction. If the broker was

holding the order and had discretion to fill it, the time from
quote to execution could be as fast as 10 seconds or less.

There was some skill on the brokers end; The broker needed
to know what direction the market was leaning. In his head
he was thinking, I could sell 10,000 synthetic puts in a heart-
beat, but I will have to pull teeth for 5,000 buy writes.

As a floor trader, knowing what the customer wanted to do

and knowing how to hedge it, in case things went south, were
3

iBooks Author
of upmost importance. After all, option traders are only as
good as their last trade.

The reality was, the broker was quoting a put, but no puts
were actually going to trade. Calls and stock were going to
trade and hit the tape in short order.

However, the calls and stock acted like puts and had
the risk profile for puts. They were not just puts but
synthetic puts. Two securities ginned up to act like
another security.

The traders job was to know what was quoted, what was trad-
ing, how to price it, and how to hedge it all as fast as possible.

Now back to that initial order and the idea of a synthetic

option.

One of the best things about trading stock options, from

either the pro-trader or retail side, is the fact that it is
possible to combine options and stock to make other options.
This position is called a synthetic option.

The key to trading options successfully is to know how an

option is going to perform given a set of inputs and positions.
The way to do that is to understand how the synthetic equiva-
lence of options works for all trade types. Once a trader has
this down, half the battle is done. The market can always sur-
prise, but how the position performs should not.

iBooks Author
C HAPTER 2

What &
Where Do
These
Synthetic
Options
Come From?

iBooks Author
First and foremost, there has to be a passing understanding of
exercise and assignment to build the base of option knowl-
edge. ACTION OPTION STEP 1 STEP 2

Before a new trader executes a trade, they must understand Exercise Long Call Sell long call Buy Stock
the mechanics behind it. The mechanism of exercise is buried
Exercise Long Put Sell long put Sell Stock
in the formal definition of an equity option for a call and a
put. Assignment Short Put Buy short put Buy Stock

That definition is: Assignment Short Call Buy short call Sell Stock

A call is the right to buy 100 shares of an underlying
security for a certain price (strike price) over a certain
period of time (expiration month).
When exercising a long call, the action is selling the long call
(-C) and buying the stock (+S)
When exercising a long put, the action is selling the long put
(-P) and selling the stock (-S)

A put is the right to sell 100 shares of an underlying
security for a certain price (strike price) over a certain
period of time (expiration month).
So when the holder of an option exercises or gets assigned the
position through election before or on expiration day, the char-
acter of the position changes a bit.
(Note that this is American Exercise only. European-Style
Options can only be exercised or assigned on expiration.)
Assignment of a short put, the action is buying in the short
put (+P) and buying the stock (+S)
Assignment of a short call, the action is buying in the short
call (+C) and selling the stock (-S)
Think about this for a second.
For the above transaction types, the activity is to first close the
current option position and then take the appropriate underly-
ing position.

The conversion of options to stock is the core basis for the During exercise or assignment, an implicit transaction has oc-
synthetic equivalence in options. We can examine this in a curred vis--vis the old option position and the new underly-
simple table.
6

iBooks Author
ing position. That transaction is our synthetic equivalent in
options.

The synthetic relationship is controlled by what is known as

Put/Call Parity.

iBooks Author
C HAPTER 3

Put/Call
Parity

iBooks Author
Put/Call Parity in options is the other puzzle piece for

($2 - $1) + $20 = $21
synthetic equivalence.
Note the synthetic stock and actual stock are trading at the
By combining a call and a put of the same strike in the same same price.
month together, the equivalent of stock is created.
To calculate synthetic Short Stock from the screen:
Simply put (no pun intended):

OPT is trading $21

A long call + a short put = long stock or C P = S

The OPT Nov 20 call is trading for $2

A short call + a long put = short stock or -C + P = - S

The OPT Nov 20 put is trading for $1
How does an option trader create synthetic stock? The simple
The formula is C + P = -S for short stock
way is to price it in the market. The above relationships make
it easy to pull the prices right out of the market, plug them To relate to the screen market
into the formula, and calculate how this all works.

(- Call premium + Put premium) + Strike Price
For our example, the listed stock Option Pit (OPT) would look
like this: Note there is a credit from the minus sign.

OPT is trading $21

(-$2 + $1) + $20 = $21 the synthetic stock and actual stock
are trading at the same price

The OPT Nov 20 call is trading for $2
When the option prices are combined, that creates a credit or

The OPT Nov 20 put is trading for $1 a debit that is added to the strike price. That tells us where
the synthetic stock is trading.
To calculate synthetic long stock from the screen:

The formula is C P = S for long stock

To relate to the screen market

(Call Premium Put Premium) + Strike Price

iBooks Author
T O BUY SYNTHETIC STOCK : The easiest way to understand risk is to just follow the prices
(P/L) of the options when the underlying moves up and down.
Add the debit to the strike price (as in our example) or
For long synthetic stock, as the underlying moves up, the long
subtract the credit (sometimes this is how they trade) from
call takes over, and the short put drops out of the picture.
the strike price.
When the underlying moves down, the short put takes over
What this does is establish the effective synthetic stock price
the profit and loss (P/L) so in aggregate the whole position
where the position was initiated by using the strike. Adding
looks just like a long position in the underlying security.
the calls and puts together tells us exactly where the underly-
ing security is trading using the option prices.

From a risk point of view, look at a chart of all three trades on

one graph:

10

iBooks Author
T O SELL SYNTHETIC STOCK : As an exercise, pull up an option quote screen after reading
this ebook and practice the arithmetic of buying and selling
Add the credit to the strike price for the synthetic stock sale,
synthetic stock on one expiration month.
or subtract the debit from the strike price on the synthetic
stock sale.
Use the liquidity provider way, buy on the bid and sell on
the offer, to tell if the screens are priced efficiently.

Just read the option quote screen and add up the debits and
credits on each strike. Now notice that calls and puts are pric-
ing synthetic stock on every series (option chain) in a particu-
lar class of options.

The synthetic stock prices are moving tick by tick to reflect the
price of the underlying security. Relating synthetic stock pur-
chase in one strike and a synthetic stock sale in another strike
is known as a Box.

Buying synthetic stock and selling synthetic stock is just open-

ing and closing a transaction, but in a Box the relationship is
Now look at the short synthetic stock risk profile, just follow carried to expiration. Before using the Box to relate strikes,
the P/L in the same way as in the long synthetic stock exam- use Put/Call parity to round out the balance of the basic
ple. synthetic relationships.

As the underlying tanks, the long puts take over for the short Put/Call Parity defines the relationships between calls, puts,
calls as they decrease to 0. As the underlying moves up, the and stock. By rearranging the original definition, it is simple
short call position is unprofitable with a 1 to 1 move in the un- to solve for the remaining synthetic options we are looking
derlying and the long puts collapse to 0. This risk profile for.
looks just like a short underlying position.

Long stock = long call + a short put
S= CP

11

iBooks Author

Short stock = short call + a long put - S = -C + P From Put/Call Parity, the exercise or assignment of options is
just the equivalent of the synthetic transaction. The original

Long call = long put + long stock

C=P+S
definition for a call or put is realized in the exercise of options.

Short call = short put + short stock

-C = -P S
Calls can be synthetically converted to puts, and puts can be

Long put = long call + short stock

P=CS synthetically converted to calls with the rules governed by the
exercise definition in options.

Short put = short call + long stock

-P = -C + S
Now we have the underlying structure to price that brokers
Looking back at the Exercise/Assignment table, notice how original question from the beginning paragraph, buy write/
certain transactions look just like a synthetic equivalent: synthetic put, what is the market? We know what it is, so
lets go price it.
When exercising a long call, the action is selling the long call
(-C) and buying the stock (+S),

so exercising the long call is the same thing as selling the put
synthetically.

When exercising a long put, the action is selling the long put
(-P) and selling the stock (-S),

so exercising a long put is the same thing as selling the call

synthetically.

Assignment of a short put, the action is buying the short put

in (+P) and buying the stock (+S),

so getting assigned a short put is the same thing as buying

the call synthetically.

Assignment of a short call, the action is buying the short call

in (+C) and selling the stock (-S), so getting assigned a short
call is the same thing as buying the put synthetically.
12

iBooks Author
M AKING A SYNTHETIC
For the stock OPT, find the synthetic put from the screen
option prices and the underlying stock: Our formula from
above is P= C S for a long synthetic put or P = -C + S for a
short synthetic put.
Price it in the market:
other side of the strike. The screen market here is priced effi-
ciently using $21 as the underlying price.
Taking the screen price is one thing, but usually it helps to
look at how the synthetic puts breaks out on a risk graph. That
way, following the movement of the component parts should
equate to the whole piece.

OPT is trading $21

Calls

OPT

Puts

$2- $2.1
Nov 20
$1 - $ 1.10

The OPT Nov 20 call is trading for $2 on the bid.

To find market prices, the idea is to take the intrinsic value

out of the calculation.

Intrinsic value is the amount the option is in the money

We adjust the difference in the strike and stock price accord-

ingly. For our example, the idea is to give the market from the
liquidity providers/floor traders perspective.
The formula is [(Strike + Call Premium) Stock Price] to cal-
culate the screen market for a synthetic put.
For the long synthetic put, Put/Call Parity says to add the call
to a short stock position (1 call for 100 shares) to create the
synthetic option. Follow the P/L up and down to understand
the action.

($20 + $2) - $21 = $1 and ($20 + $2.1) - $21 = $1.10. The buy As the underlying moves up, the long call and short stock can-
write/synthetic put market is $1 bid at $1.10. Note how those cel each other out since, for a $1 move up, the call is gaining
synthetic markets look just like the quoted put markets on the what the short stock is losing. On the way down, the long call

13

iBooks Author
goes to 0, but the short stock keeps gaining profits. The
screen market will dictate what the break even prices are.
Calls
OPT
Puts
$2- $2.1
Nov 20
$1 - $ 1.10
[(Stock Price + Put
For the short synthetic put, we have the opposite looking
graph that we had with the long synthetic put. Follow the un-
derlying move up; the long stock profits are consumed by the
short call losses. As the underlying slides down, long stock
losses take over as the short call goes to 0.
Now price the synthetic calls:
C = S + P for the long synthetic call
or
C = -S P for the short synthetic call
iBooks Author
OPT is trading $21
We still take the intrinsic value out of the calculation. We ad-
just the difference in the strike and stock price
accordingly.This looks a little different since we subtract out
the strike price. From the liquidity providers/floor traders
perspective the equation looks like:
Premium) Strike Price] to calculate the screen market for a
synthetic call.
($21 + 1) - $20 = $2 and ($21+ $1.1) - $20 = $2.10. The
synthetic call market is $2 bid at $2.10. Note how those
synthetic markets look just like the quoted call markets on the
other side of the strike. The screen market here is priced effi-
ciently using $21 as the underlying price. Practice this with
calls, puts, and stock using different prices after finishing this
E-book. With some time,the pricing mechanism for synthetic
options becomes familiar.
To round out the balance of the basic synthetic option discus-
sion, look at the risk graphs of the long and short synthetic
call.
14
Follow the direction of the underlying stock up, where the
long stock takes over as the long put declines to 0. As the un-
derlying stock moves down, the long put and long stock start
to cancel each other out leaving with a net flat P/L after the ini-
tial debit established by the synthetic screen prices. This is
the same risk profile as a long call.
The short synthetic call risk profile adds together the short
put and short stock. As the stock price increases, the losses
from the short stock position take over once the short put goes
to 0. As the stock price tanks, the short stock and short put
cancel each other out leaving the initial credit from the
synthetic screen markets. Again, this is just the short call risk
profile.

15

iBooks Author
C HAPTER 4

Adding In
Cost of Carry

Adding onto Put/Call parity to

understand the complete options trade

iBooks Author
I am betting (slightly) on the fact that you did not go immedi- Increase the synthetic price by (interest rates dividend)
ately to a screen and price synthetic options.

Short call = short put + short stock
-C = -P S
If so, especially in an option class with dividends, there would
Increase the synthetic by (Interest rates dividend)
be some prices that look a little askew when creating synthetic
options. The reason, most likely, is cost of carry.
Long put = long call + short stock
P = C S
Any time a trader combines stock and options together, cost Reduce the synthetic by (interest rates dividends)
of carry comes into play, because as a long or short holder of
stock, dividends and interest tag along for the ride.
Short put = short call + long stock
-P = -C + S

Stock owners receive dividends, and short sellers of stock pay Reduce the synthetic by (Interest rates dividends)
them. For interest rates, long holders of stock pay interest,
and short sellers, in general, collect interest.
Note: Interest Rate calculation:
By adjusting the synthetic option position prices with the cost
of carry, this should add up to the amount of the actual call, (Strike Price * Interest Rates * (Time to Expiration/360))
put, or stock price.

Long stock = long call + a short put
CP=S
If we assume interest rates and dividends are zero, cost of
carry does not factor into the synthetic options pricing, which
Note: a combination is a position with a call AND a put.
helps when first learning Put/Call Parity.

Also, note that the debits and credits are added to or sub-
Decrease the combination price by (interest rates dividend)
tracted from whatever the expected cash flow is from the long

Short stock = short call + a long put
-C + P = - S or short stock position. What happens with the underlying dic-
tates how the cost of carry works.
Decrease the combination price by (Interest rates dividend)
We started with a floor broker quoting a synthetic put. A good

Long call = long put + long stock

C=P+S floor trader knows how to quote everything, because that is
what customers want.

17

iBooks Author
From a position management point of view knowing how a
trade acts, how the various parts are related, and how they
move together are vitally important.

The reason for knowing synthetic option positions helps

a trader understand what the option position really is.

18

iBooks Author
C HAPTER 5

When a Call
Spread is a
Put Spread

Synthetic positions are about finding

other ways to construct the same risk

iBooks Author
S ECTION 1 of the money options. The synthetic relationships control the
same strikes, and the Box controls between strikes.
Creating A Long Box The value of the Box is just the cost of carry for the difference
Position between the strikes. For our examples, we will assume a cost
of carry of 0 (no dividends and near 0 interest rates).

A Long Box is long a call spread and a put spread at the same
time. Clip a leg out of the Box trade above, and what is left?

Look at the Nov 22 combination for $ .90 (short synthetic

stock $21.10) for and the long Nov 20 calls for $2. That is just
the long synthetic Nov 20 put for $ .90. The Long Box is
We covered buy writes from both the long and short side of
closed by selling out the Nov 20 put.



the trade. Now that a call can turn into a put by just shorting
stock against it, there are a few more interesting observations

Calls
OPT

Puts
to make. First lets review the Box.


$2- $2.1
Nov 20
$1 - $ 1.10



Calls
OPT

Puts


$1-$1.1
Nov 22
$2 -$2.10



$2- $2.1
Nov 20
$1 - $ 1.10

$1-$1.1
Nov 22
$2 -$2.10

L ONG B OX
From the previous discussion, a Box is a long synthetic stock
position in one strike and a short synthetic stock position in
another strike.

The example shows how a Box is priced. For a Long Box

position, the position is long deep options and short more out
20

iBooks Author
S ECTION 2 The credit for the call spread is the same as the debit for the
put spread just subtract the call spread value from the differ-
Short Boxes ence in the strikes. Those out of the money call spreads that
look so tempting are really just the ITM put spreads. Those
out of the money put spreads are just the in the money call
spreads. Synthetic relationships guarantee it.

Calls
OPT

Puts

$2- $2.1
Nov 20
$1 - $ 1.10

$1-$1.1
Nov 22
$2 -$2.10

The Short Box is just the opposite. Selling the deep call
spread and deep put spread creates the two synthetic stock
combinations. A SHORT CALL SPREAD IS A LONG PUT SPREAD
Using the sample above, find the P/L at $20 and $22. At $20
If closing the Short Box means selling two spreads, then what
the short 20/22 call spread is worth 0, so the trade is up by
does buying one spread and selling another get? In the Short
$1.1.
Box figure at the end of the prior section, a short Nov 20/22
call spread is priced for $1.1 credit. At $20, the long 20/22 put spread that was .90, is now worth
$2. Both trades made $1.1. Work the long call spread and
The spread can be only worth the difference in the strikes,
the short put spread. It will show the same thing.
since the relationship is locked by the Box. The short put
spread closes the short call spread, and when trading the op-
posite namely buying the Nov 20/22 put spread the Credit spreads are not really income trades; they are
position would be open and not boxed off. just long spreads on the other side in disguise.

Selling the short call spread has to be the same as buying the
long put spread, except for the difference in the strikes for By understanding that, the spreads are the same when execut-
Put/Call Parity, to work out. ing an order, they always go to the side that has the best price.

21

iBooks Author
C HAPTER 6

The Collar
Trade

iBooks Author
The reason Collars are popular is that the investing public,
hedge funds and asset managers, in general, are long stock.
When things get dicey, buying puts becomes useful to help
manage the risk of the long stock position. By adding a
position of a long put of a lower strike and a short call of a
higher strike, this helps reduce the risk of the position in two
ways:
trader can either buy in the short call or sell out the long put.
There is lots of time to make the decision, in fact, right up un-
til expiration. The Collar with long stock buys flexibility at the
small cost of giving away some of the upside.
In a turbulent market, this trade might make sense, and know-
ing how it really performs keeps the investor prepared for
whatever might happen.

1.
The debit paid for the put is reduced by the call sale

2.
The put helps lower the risk in owning stock

By now, that should sound familiar.

Adding long stock to a long put is just a long synthetic call.

The collar still has a short call to go with it, so in effect, the
position is now just a long synthetic call spread.

Wait!

There is more. A long call spread is just a short synthetic put

spread. By adding a collar to stock, that just changes the
position to a short put spread. The risk reward profile will
look exactly the same.

The magic of synthetic positions is that, while they perform

the same from a P/L standpoint, there are components trad-
ers can do something with.

A collared stock position has some flexibility. If the stock tum-

bles and there is commitment for owning the underlying, the

23

iBooks Author
Putting It All
Together

Equivalence in positions is an important

foundation concept in options trading.

Option Pit teaches this - and the rest of

what you need to know - to be a
successful options trader.

Check out the rest of our educational

offerings at www.optionpit.com

iBooks Author