Option Investor
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Tools of the Trade

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In the previous segment we discussed the benefits of using synthetic positions to speculate on trending issues. Recall that synthetic positions are simply alternate ways of constructing the same risk-versus-reward outlook with different instruments. Using options, traders can capitalize on expected movement in stocks without investing as much capital as they would when buying the underlying shares on the open market. In addition, the leverage inherent in derivatives can generate exponential returns when the expected directional activity occurs in a timely manner.

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There a number of advantages to using a bullish, synthetic (option) position however this approach also has an obvious drawback; the substantial capital risk, which is equivalent to stock ownership. Although the initial collateral requirements for a synthetic position are much lower than being "long" in the stock, a sharp unexpected decline in the underlying issue may result in its physical delivery through assignment of the sold (short) put. In fact, the obligation of the option writer -- to purchase the underlying upon exercise by the owner - is the reason a margin account is necessary to participate in this strategy. While margin in itself is not a problem, the downside potential associated with selling "naked" puts is something that must be managed effectively in order to be successful with synthetic positions in the long run.

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