How to Make Calls Into Puts

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2 CHAPTER 1 How to Make Calls Into Puts Or... There is no such thing as a credit spread

3 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 OPTIONS, or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois ii

4 SECTION 1 Introduction IN THIS SECTION: 1. Using puts to make calls and stock to make options. 2. Understanding risk profiles 3. How Synthetic Options help you understand your trades One of the first things professional option floor traders (when there were professional floor option traders) learn to quote 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, what comes at $1.75. The floor brokers are always peddling their paper. Their job, of course, is trying to get customers filled. It always gives me 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 it done and done in a hurry. Like sheep, we would fill the order 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 broker s 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 heartbeat, 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

5 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 trader s job was to know what was quoted, what was trading, 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 equivalence of options works for all trade types. Once a trader has this down, half the battle is done. The market can always surprise, but how the position performs should not. 4

6 CHAPTER 2 What & Where Do These Synthetic Options Come From?

7 First and foremost, there has to be a passing understanding of exercise and assignment to build the base of option knowledge. Before a new trader executes a trade, they must understand the mechanics behind it. The mechanism of exercise is buried in the formal definition of an equity option for a call and a put. That definition is: ACTION OPTION STEP 1 STEP 2 Exercise Long Call Sell long call Buy Stock Exercise Long Put Sell long put Sell Stock Assignment Short Put Buy short put Buy Stock 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). 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 character of the position changes a bit. (Note that this is American Exercise only. European-Style Options can only be exercised or assigned on expiration.) The conversion of options to stock is the core basis for the synthetic equivalence in options. We can examine this in a simple table. 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) 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 underlying position. During exercise or assignment, an implicit transaction has occurred vis-à-vis the old option position and the new underly- 6

8 ing position. That transaction is our synthetic equivalent in options. The synthetic relationship is controlled by what is known as Put/Call Parity. 7

9 CHAPTER 3 Put/Call Parity

10 Put/Call Parity in options is the other puzzle piece for synthetic equivalence. By combining a call and a put of the same strike in the same month together, the equivalent of stock is created. Simply put (no pun intended): A long call + a short put = long stock or C P = S A short call + a long put = short stock or -C + P = - S How does an option trader create synthetic stock? The simple 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 into the formula, and calculate how this all works. For our example, the listed stock Option Pit (OPT) would look like this: OPT is trading $21 The OPT Nov 20 call is trading for $2 The OPT Nov 20 put is trading for $1 To calculate synthetic long stock from the screen: ($2 - $1) + $20 = $21 Note the synthetic stock and actual stock are trading at the same price. To calculate synthetic Short Stock from the screen: OPT is trading $21 The OPT Nov 20 call is trading for $2 The OPT Nov 20 put is trading for $1 The formula is C + P = -S for short stock To relate to the screen market (- Call premium + Put premium) + Strike Price Note there is a credit from the minus sign. (-$2 + $1) + $20 = $21 the synthetic stock and actual stock are trading at the same price When the option prices are combined, that creates a credit or a debit that is added to the strike price. That tells us where the synthetic stock is trading. The formula is C P = S for long stock To relate to the screen market (Call Premium Put Premium) + Strike Price 9

11 TO BUY SYNTHETIC STOCK: Add the debit to the strike price (as in our example) or subtract the credit (sometimes this is how they trade) from the strike price. What this does is establish the effective synthetic stock price where the position was initiated by using the strike. Adding the calls and puts together tells us exactly where the underlying security is trading using the option prices. The easiest way to understand risk is to just follow the prices (P/L) of the options when the underlying moves up and down. For long synthetic stock, as the underlying moves up, the long call takes over, and the short put drops out of the picture. When the underlying moves down, the short put takes over the profit and loss (P/L) so in aggregate the whole position looks just like a long position in the underlying security. From a risk point of view, look at a chart of all three trades on one graph: 10

12 TO SELL SYNTHETIC STOCK: Add the credit to the strike price for the synthetic stock sale, or subtract the debit from the strike price on the synthetic stock sale. As an exercise, pull up an option quote screen after reading this ebook and practice the arithmetic of buying and selling synthetic stock on one expiration month. 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 pricing synthetic stock on every series (option chain) in a particular class of options. The synthetic stock prices are moving tick by tick to reflect the price of the underlying security. Relating synthetic stock purchase in one strike and a synthetic stock sale in another strike is known as a Box. Now look at the short synthetic stock risk profile, just follow the P/L in the same way as in the long synthetic stock example. As the underlying tanks, the long puts take over for the short calls as they decrease to 0. As the underlying moves up, the short call position is unprofitable with a 1 to 1 move in the underlying and the long puts collapse to 0. This risk profile looks just like a short underlying position. Buying synthetic stock and selling synthetic stock is just opening and closing a transaction, but in a Box the relationship is carried to expiration. Before using the Box to relate strikes, use Put/Call parity to round out the balance of the basic synthetic relationships. Put/Call Parity defines the relationships between calls, puts, and stock. By rearranging the original definition, it is simple to solve for the remaining synthetic options we are looking for. Long stock = long call + a short put S = C P 11

13 Short stock = short call + a long put - S = -C + P Long call = long put + long stock Short call = short put + short stock Long put = long call + short stock Short put = short call + long stock C = P + S -C = -P S P = C S -P = -C + S Looking back at the Exercise/Assignment table, notice how certain transactions look just like a synthetic equivalent: When exercising a long call, the action is selling the long call (-C) and buying the stock (+S), From Put/Call Parity, the exercise or assignment of options is just the equivalent of the synthetic transaction. The original definition for a call or put is realized in the exercise of options. Calls can be synthetically converted to puts, and puts can be synthetically converted to calls with the rules governed by the exercise definition in options. Now we have the underlying structure to price that broker s original question from the beginning paragraph, buy write/ synthetic put, what is the market? We know what it is, so let s go price it. 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

14 MAKING 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 efficiently 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 accordingly. 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 calculate the screen market for a synthetic put. ($20 + $2) - $21 = $1 and ($20 + $2.1) - $21 = $1.10. The buy write/synthetic put market is $1 bid at $1.10. Note how those synthetic markets look just like the quoted put markets on the 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. As the underlying moves up, the long call and short stock cancel each other out since, for a $1 move up, the call is gaining what the short stock is losing. On the way down, the long call 13

15 goes to 0, but the short stock keeps gaining profits. The screen market will dictate what the break even prices are. OPT is trading $21 Calls OPT Puts $2- $2.1 Nov 20 $1 - $ 1.10 We still take the intrinsic value out of the calculation. We adjust 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: [(Stock Price + Put Premium) Strike Price] to calculate the screen market for a synthetic call. For the short synthetic put, we have the opposite looking graph that we had with the long synthetic put. Follow the underlying 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: or C = S + P for the long 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 efficiently 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 discussion, look at the risk graphs of the long and short synthetic call. C = -S P for the short synthetic call 14

16 Follow the direction of the underlying stock up, where the long stock takes over as the long put declines to 0. As the underlying stock moves down, the long put and long stock start to cancel each other out leaving with a net flat P/L after the initial 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

17 CHAPTER 4 Adding In Cost of Carry Adding onto Put/Call parity to understand the complete options trade

18 I am betting (slightly) on the fact that you did not go immediately to a screen and price synthetic options. If so, especially in an option class with dividends, there would be some prices that look a little askew when creating synthetic options. The reason, most likely, is cost of carry. Any time a trader combines stock and options together, cost of carry comes into play, because as a long or short holder of stock, dividends and interest tag along for the ride. Stock owners receive dividends, and short sellers of stock pay them. For interest rates, long holders of stock pay interest, and short sellers, in general, collect interest. By adjusting the synthetic option position prices with the cost of carry, this should add up to the amount of the actual call, put, or stock price. Long stock = long call + a short put C P = S Note: a combination is a position with a call AND a put. Decrease the combination price by (interest rates dividend) Short stock = short call + a long put -C + P = - S Decrease the combination price by (Interest rates dividend) Long call = long put + long stock C = P + S Increase the synthetic price by (interest rates dividend) Short call = short put + short stock -C = -P S Increase the synthetic by (Interest rates dividend) Long put = long call + short stock P = C S Reduce the synthetic by (interest rates dividends) Short put = short call + long stock -P = -C + S Reduce the synthetic by (Interest rates dividends) Note: Interest Rate calculation: (Strike Price * Interest Rates * (Time to Expiration/360)) If we assume interest rates and dividends are zero, cost of carry does not factor into the synthetic options pricing, which helps when first learning Put/Call Parity. Also, note that the debits and credits are added to or subtracted from whatever the expected cash flow is from the long or short stock position. What happens with the underlying dictates how the cost of carry works. We started with a floor broker quoting a synthetic put. A good floor trader knows how to quote everything, because that is what customers want. 17

19 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

20 CHAPTER 5 When a Call Spread is a Put Spread Synthetic positions are about finding other ways to construct the same risk

21 SECTION 1 Creating A Long Box Position of the money options. The synthetic relationships control the same strikes, and the Box controls between strikes. The value of the Box is just the cost of carry for the difference 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? We covered buy writes from both the long and short side of the trade. Now that a call can turn into a put by just shorting stock against it, there are a few more interesting observations to make. First let s review the Box. Calls OPT Puts $2- $2.1 Nov 20 $1 - $ 1.10 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 closed by selling out the Nov 20 put. Calls OPT Puts $2- $2.1 Nov 20 $1 - $ 1.10 $1-$1.1 Nov 22 $2 -$2.10 $1-$1.1 Nov 22 $2 -$2.10 LONG BOX 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

22 SECTION 2 Short Boxes The credit for the call spread is the same as the debit for the put spread just subtract the call spread value from the difference 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. If closing the Short Box means selling two spreads, then what does buying one spread and selling another get? In the Short Box figure at the end of the prior section, a short Nov 20/22 call spread is priced for $1.1 credit. The spread can be only worth the difference in the strikes, since the relationship is locked by the Box. The short put spread closes the short call spread, and when trading the opposite namely buying the Nov 20/22 put spread the position would be open and not boxed off. Selling the short call spread has to be the same as buying the long put spread, except for the difference in the strikes for Put/Call Parity, to work out. A SHORT CALL SPREAD IS A LONG PUT SPREAD Using the sample above, find the P/L at $20 and $22. At $20 the short 20/22 call spread is worth 0, so the trade is up by $1.1. 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 short put spread. It will show the same thing. Credit spreads are not really income trades; they are just long spreads on the other side in disguise. By understanding that, the spreads are the same when executing an order, they always go to the side that has the best price. 21

23 CHAPTER 6 The Collar Trade

24 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 until 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 knowing 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 traders can do something with. A collared stock position has some flexibility. If the stock tumbles and there is commitment for owning the underlying, the 23

Option Pit teaches this - and the rest of what you need to know - to

25 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

Learn To Trade Stock Options

Learn To Trade Stock Options Written by: Jason Ramus www.daytradingfearless.com Copyright: 2017 Table of contents: WHAT TO EXPECT FROM THIS MANUAL WHAT IS AN OPTION BASICS OF HOW AN OPTION WORKS RECOMMENDED