Call and Put Synthetics

A synthetic trade involves buying a call and selling a put with the same strike price and expiration date or vice versa depending on your outlook for the stock. A Long Synthetic is the name for the bullish trade option, where a call is bought and a put is sold.

The effect of these call and put synthetics is similar to just buying a basic call option, where your profits are unlimited the higher the stock climbs. However, there are a few key differences. Firstly, a long synthetic requires you to sell a put option. Doing so means you will need to close this position before expiration to prevent the put option being exercised.

As can be seen, buying a basic call option means that the maximum you will lose is the premium of that call. However, you won't start to see profits till the stock climbs a bit higher than the strike price of the option. In a long synthetic, selling a simultaneous put option changes both these characteristics.

By combing the profit charts of the call purchase and put sale, it can be seen that the potential loss of the trade has become unlimited. In a basic call option, the maximum you will lose is the premium you spent buying that call. In a long synthetic however, you have an open put option which you will need to buy back before expiration, and that put option will cost more the lower the stock price becomes.

However, with this extra risk comes couple of key benefits. Firstly, because you are selling a put option (thus earning premium) together with buying a call, the long synthetic becomes cheaper than simply buying a call. In addition, by adding the profit charts of the call purchase and put sale together, you can see that this position starts to see a profit as soon as the stock goes over the strike price.

A Short Synthetic is basically the opposite of the long synthetic position. This is a strategy for when you are particularly bearish on a stock. You buy a put option while simultaneously selling a call option at the same strike price with the same expiration date.

Similar to the above scenario, if you had only bought a basic put option, you don't start seeing profit till the stock goes a bit below the strike price. On the other hand, a basic put will cost you the full cost of the put option's premium, and your maximum loss is that premium.

Conversely, a short synthetic allows you to see profit the moment your stock goes below the strike price, and the initial premium spent on the put option is offset by the amount made selling the corresponding call option. However, these advantages come with a big caveat: you now risk unlimited losses. If the stock keeps climbing higher and higher, the cost to buy back the call option before expiration will increase correspondingly, making this position very costly if you wrongly predict the direction of the stock movement.

A lot of people think of synthetics as a cheap way of playing basic options, since the option premiums are offset by selling the opposite option contracts. However, please bear in mind that this position is similar to trading in futures. If you wrongly predict the stock direction, call and put synthetics can become very costly.

For a more detail on long and short synthetics, please visit: http://www.option-trading-guide.com/synthetics.html

Steven is the founder of the Option Trading Guide at http://www.option-trading-guide.com , a website that provides information on trading stock options and technical analysis techniques.