by Dawn Pennington 03/18/08
You can create synthetic stock positions by using options. That is, either by buying a call and selling a put (to simulate a long stock position) or by selling a call and buying a put (to simulate a short stock position) in a 1-to-1 ratio to generate similar returns to owning a "real" stock position but by risking far less.
But did you know that you could also simulate a call or a put option position by using a combination of stock and the opposite type of option? (That is, you can create a call with the stock and a put, or simulate a put with the stock and a call.)
Because it's wise to have a balance of bullish and bearish positions in your trading account, let's examine how we can establish synthetic put positions.
You can simulate both long puts and short puts with a combination of stock (whether long or short) and call options (again, either long or short, depending on the desired result).
As you may know, a long put is a bearish strategy whereby you are expecting the stock price to drop below the strike price of the option you buy. When purchasing a put, the most you can lose is what you invest, and the upside can be unlimited.
A traditional short put is a bearish strategy, as when you write (or sell to open) a put option, you're looking for the stock to go up. As with any short position established without some type of hedge (which we'll talk about momentarily), the traditional short put can carry substantial risk.
To create a similar risk/reward scenario as buying a put but with a synthetic long put position, you can short the stock -- a risky maneuver when done on its own -- and couple it with a long call position.
For example, if you buy an XYZ December 50 Call and short the stock against it, the risk/reward scenario is similar to owning the XYZ December 50 Put. Here, you're looking for the stock to go down, but if it spikes through $50, but your downside is halted.
How is the true price of an option determined? Don't let it all be 'Greek' to you. We'll show you how four fraternity brothers work together to create a party in your portfolio.
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