In our last post we covered Arbitrage and Put Call Parity. Today we are going to extend the discussion and talk about Synthetic Strategies.
Let us understand this with an example.
I want to trade an ITM Call option, but there’s very little liquidity ,so impact cost is high.See the image below.The table is divided in 2 parts by middle column of strike price(1140 to 1300). Left column is for call option and right columns are for put options.For 1200 call Bid Ask prices are 47.75 & 52.35 respectively.For 1200 put it is 29-30.1.
In call there’s a spread of Rs 5,which is not helpful for trading. A trader always looks for tight bid-ask spreads.In order to enjoy similar payoff of a call option i can use a synthetic call strategy. For this we will use the formula of Put-Call Parity.
Put+Futures = Call +Strike
So using this formula Call=Put+Futures-strike. Since strike is a constant figure in this equation we can use the formula –
Put+Futures = Call
So if i want to go long in 1200 call option , the alternate i can choose to do is Long futures & Long 1200 put option, that will give me the same Profit/Loss like 1200 call option. Let us analyze this position further
One crucial benefit of synthetic is Rolling over of the trade.Let’s say i am bullish on State bank of India. And i decided to short put/long call on current expiry.However i want to carry my trade for more than a month; 6 months. Carrying a trade for 6 months will require you to roll over your positions into next month as only 3 months contract are available in stocks. Some stocks in options segment in Indian derivatives market are not liquid enough to carry a same position every month, so using futures to roll over your position with corresponding options makes sense in this case. It is easier to carry over your position in futures than in options.
Another benefit of the synthetic positions are multiple entry/exit opportunities. Since synthetic positions are built by 2 contracts you can do partial entry/exits based on your analysis. It’s an additional choice one has.
Some of the bottlenecks of the strategy are –
- High margin required
- Roll-over cost
- Transaction cost and slippages
Few commonly used strategies are-
- Covered Call
- Protective Put
- Synthetic Stocks
Below is the able showing various Vanilla position and their respective Synthetic position.
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