No doubt you’ve heard negative things about options – such as, they’re too hard to understand or they’re risky.
But as we saw recently when we checked out how market makers work, understanding options can help you gain a better appreciation of risk and reward with your trading.
And that’s true even if you decide to stick with just trading shares.
Today, I want to expand on this theme with a new example…
Hedging Options Positions
To briefly recap, market makers can hedge their position when they sell you a call option.
To achieve that hedge, they need to replicate your bought call option position. They can do this by simultaneously buying the underlying shares and a put option.
The reason that acts as a hedge is that it has the same risk/reward profile as buying a call option.
A call option lets you capture the upside of a rally with the limited risk of the price you paid for the option. If the stock price tanks, the most you lose is the premium.
Buying shares and a put option achieves the same thing…
The shares let you capture any upside. But the put option (using the same strike price you bought the shares at) means that you can exit the stock at the same price you bought them.
So even if the stock price tanks, you can simply exercise your put option.
Under this scenario, as well, the most you can lose is the premium you paid for the put option.
“Synthetic Equivalent”
Using options jargon, we say that these two strategies are “synthetically equivalent.” That term might be a mouthful, but it simply means that each scenario has the same risk/reward setup.
Yet some investors think that buying shares and a put option to protect themselves is a “safe” way to trade but buying a call option is “risky.”
True, a call option has an expiration date. If the move you hoped for doesn’t pan out in time, then you’re going to burn up your premium.
But the same applies to a put option. From the moment you buy your put option to protect your shares, the clock is ticking through expiry.
If the move you were protecting yourself from doesn’t play out, then you’re going to burn up your premium.
It’s important to keep this kind of thinking when considering other strategies too. There are other strategies that some might assume have different risks and rewards, but they are synthetically equivalent.
Like buying shares.
If you tried to replicate the same risk/reward profile, how would you construct it?
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Breaking It Into Component Parts
Buying a call option enables us to capture an up move in the stock.
But that comes with limited risk (the call option premium). A stock, on the other hand, has the potential to go all the way to zero.
To match the same risk/reward profile as buying stock, we’d need to add a written put option position.
By writing a put option, we are obligating ourselves to buy the underlying stock at the strike price, if the put buyer exercises their option.
So let’s check out an example with a stock trading at $50.
If we just buy the stock, our upside is potentially infinite… but we can also potentially lose all of our $50 per share.
Now consider its synthetic equivalent.
By selling a put option at $50, we agree to buy the stock at $50 if our option is exercised. Just like buying stock, the underlying stock price still has the potential to go all the way to zero.
Yet in combination with a bought call option with a $50 strike price, we can take part in any up-move.
So a written put and a bought call combined are synthetically equivalent to buying stock.
Better Understanding Risk
To be clear, I’m not suggesting you just go out and write any old put options.
I’m using this example as a mental exercise to highlight how some folks might misunderstand risk.
They might be happy to buy shares.
But they would never consider writing a put option and buying a call option, as they consider it too risky.
Yet both strategies share the same risk/reward profile.
At first glance, these synthetic strategies might seem a little confusing. But once you get your head around them, they can greatly enhance your understanding of risk.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
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