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It's Good To Be Back!

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By: Lee Lowell

The last six weeks have been very interesting to say the least. My wife was involved in an automobile accident at eight months pregnant (she and baby were fine). We moved residences two weeks after that, had to find a new car, gave birth to my second daughter, and had to fight this awful bear market with too many open positions. Talk about the levy breaking. It has probably been the hardest/worst month of my trading career. There are some circumstances that you just cannot prepare for and if you are in the trading business, this is why we preach strict money management rules. As I wrote in my last piece about the risks of trading, I wish I was more adamant about following those rules. As you never know what events will occur in your life, let's all set those stops and keep the profits.

I want to talk about "synthetics" and "equivalent positions" as they apply to options trading. "Synthetics" is a term that describes different option strategies that have the same outcome. Did you know that a "covered call" and the sale of a "naked put" will yield the same position? They have the same risk/reward profile, yet your broker probably will only let you execute the covered call. Let's break it down. When you sell a covered call, your upside profit is limited once you hit your short call, and your downside loss is unlimited (to the point of the stock going to zero). When you sell a naked put, your upside profit is limited to the amount of premium you sold the put for, and your downside loss is unlimited (to the point of the stock going to zero). The absolute numbers will be different in the end, but the risk/reward is exactly the same - limited profit, unlimited loss. Sounds the same to me.

So what's the difference then? Not much. With a covered call, if the option expires worthless, you still keep your stock and you can repeat the process. The naked put sale does not involve any stock transactions. If the put expires worthless, you can also repeat the process. The covered call requires two transactions with two commissions. The naked put sale requires only one commisssion. The covered call requires you to spend the cash on the 100 shares of stock, which can be expensive. The naked put requires no outlay of cash and you receive the credit right into your account. And at times, put options usually have higher implied volatilities than calls because of the downside fear factor. So you may get more bang for your buck by selling a put. So why won't your broker let you sell naked puts? Once again, because of the downside fear factor and the "unlimited loss" potential. Just the word "naked option" is taboo for most brokers. You can get around this obstacle only if you have a large trading account and years of trading experience that satisfies the broker. You can even try to argue with your broker that both strategies are the same, but most of them still won't go for it.

The naked put can also be used as a strategy to acquire a quality stock at a discount from today's price while receiving a credit into your account. If you want to own IBM at $100 but it's trading at $125 today, you can sell a $100 put for $3 (example)and wait to see what happens at expiration. If IBM is above $100 at expiration, you keep the $3 credit but you don't get to buy IBM at $100. If IBM is trading under $100 on expiration day, you will acquire 100 shares of IBM for $97 ($100 - $3 initial credit). That's a great way to acquire a stock you want to own at a cheaper price. And you get paid to wait for the price to come down. With a covered call, some people already own the stock from a prior period, so the sale of the call essentially reduces your initial cost basis. For those who are speculating with covered calls, then you must buy the shares first and then sell the call. Hence, the two transactions.

The same scenario applies to selling covered puts and selling naked calls. If you sell 100 shares of stock and sell a put for upside protection, it's the same as selling a naked call. With the covered put, your upside loss is totally unlimited because of the short stock, and the downside profit is limited once you hit your short put. With a naked short call, your downside profit is limited to the premium received, and the upside risk is again unlimited. The same rules apply to the number of transactions for these strategies as well. Two commissions for the covered put, and one commission for the naked call.

Slightly off the subject here, but someone e-mailed a question recently about buying calls and selling puts. What's the difference they asked. Yes, both strategies are bullish in nature, but that's where the similarity ends. When buying the call, your risk is limited and your reward is unlimited. When selling the put, your risk is unlimited and your reward is limited. That's a big difference for most people. Selling any option(call or put) has unlimited risk, but the decay factor is on your side and that's why people like to sell options. But once again, you could lose everything you own when you sell options. When you buy an option, you may lose, but you'll never lose more than what you paid for the option. Time is against you when you buy options, so timing is critical too.

Back to the synthetics. Here's a list of equivalent positions: (Note that all option strikes must be the same and same month of expiration.)

long put + long stock = long call
long call + short stock = long put
short put + short stock = short call
short call + long stock = short put
long put + short call = short stock
short put + long call = long stock

Let's take one of these equations and see how it works:

long call + short stock = long put.

The characteristic of a long put consists of unlimited profit on the downside and limited loss on the upside(the cost of the option). Now if you happen to be short 100 shares of stock, you can buy a call against it to cap your loss on the upside. But your downside profit is unlimited because you're short the stock which will keep making money on the downmove. You will lose money on the long call, but you can't lose more than what you paid for it. And if the price of the stock keeps dropping, your short stock profit will eventually overtake the loss on the long call. It's the same as owning a put option outright.

long 1 IBM July $100 call + short 100 shares IBM = long 1 IBM July $100 put.

Let's look at the outcome of the equation first, the IBM $100 put. If IBM trades below $100, you make unlimited money on your long put once you pass your breakeven. If IBM trades above $100, your put will expire worthless, but you lose no more than the price of the option. Limited loss, unlimited profit.

If you are short 100 shares of IBM, your profit is unlimited on the downside once you pass the breakeven price. Your loss is limited on the upside once your long call goes in-the-money. Limited loss, unlimited profit. Just note, whatever strike price and expiration is used in the equation, the resulting option will always have an equivalent strike and expiration.

Most of you are probably wondering why anyone would make the two transactions in the equation instead of just doing the one. It comes down to mispriced options and arbitrage opportunities. This is a much more advanced topic and mostly concerns floor traders who can quickly take advantage of these discrepancies. But for most of us off-floor traders, stick with the naked put/ covered call scenarios if allowed by your broker.

For anyone still interested in exploring the other synthetic equations, check out Sheldon Natenberg's book, "Option Volatility and Pricing Strategies".

Good luck.

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