Options Synthetics Quiz Answers

How did you do taking the quiz on Option Synthetics? In case you want a refresher, here’s an article I wrote about them that is a good summary: What everybody ought to know about Option Synthetics. We can use an easy equation to remember the synthetic relationships:

C = U + P

The relationships can be summarized in this short table:

1. Long Call = Long Stock + Long Put (C = U + P)
2. Short Call = Short Stock + Short Put (-C = -U – P)
3. Long Put = Long Call + Short Stock (P = C – U)
4. Short Put = Short Call + Long Stock (-P = -C + U)
5. Long Stock = Long Call + Short Put (U = C – P)
6. Short Stock = Short Call + Long Put (-U = -C + P)

Armed with this information, let’s go through the quiz:

1. How would you create a synthetic SHORT CALL?
That’s #2 on our summary: Short Stock + Short Put

2. How would you create synthetic LONG STOCK?
That’s #5 on our summary: Long Call + Short Put

3. How would you create a synthetic LONG PUT?
That’s #3 on our summary: Long Call + Short Stock

4. How would you hedge an out-of-the-money SHORT CALL with a synthetic position?
To completely hedge the position, use a synthetic LONG CALL at the same strike as your SHORT CALL.
Buy LONG STOCK and a LONG PUT at the same strike as your SHORT CALL.
You now have zero risk and are perfectly hedged.

5. If your underlying is near your upside expiration on a butterfly trade, how would you reduce your delta risk with a synthetic position?
If you are near the upside expiration of a butterfly, you have negative Deltas.
New need to crease your deltas. Positive delta synthetics are #1, #4 and #5 on our summary list above. Any of them should give you more positive delta. If you need a fine adjustment, use #1 or #4 as #5 (Long Stock) is +100 deltas, which might be too much, depending on your butterfly size.

6. How can you completely neutralize a 100/110 call credit spread with puts?
Create a box spread. The 100/110 call credit spread is -1 100C and +1 110C. If you add +1 100P and -1 110P you would have synthetic Short stock at 100 and synthetic Long stock at 110. This position has zero risk.

7. You are long a futures contract at $100. The contract is now at $125. How can you lock in the $25 profit without selling the futures contract over the weekend with a synthetic option position?
To lock in the $25 profit, you just need to add a synthetic short future with futures options:
-1 125C and +1 125P should give you a synthetic short future contract, which will neutralize your long future.

I hope you enjoyed the quiz. It’s good to know these relationships and practice from time-to-time with a quiz like this!

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Options Synthetics Quiz

Multiple choice examination form or customer satisfaction surveyA friend was taking an exam to get Customer Portfolio Margin for his option trading account recently.  He showed me the exam and I noticed that 20% of the exam were questions about option synthetics!  If it’s that important to an option broker, it should be important to us.

My two youngest children attend the German school system.  There are no multiple-choice exams: they are all essay questions.  You have to show your work.  Let’s do the same thing.

Write down your answers for each question.  
Explain WHY the answer is what you say it is.  Don’t just say, ___ .  Show your work…you’ll learn a lot more.   This is an open book exam since I can’t watch you, but try to answer the questions without looking anything up.  You’ll get more out of it.

Here we go

1. How would you create a synthetic SHORT CALL?

2. How would you create synthetic LONG STOCK?

3. How would you create a synthetic LONG PUT?

4. How would you hedge an out-of-the-money SHORT CALL with a synthetic position?

5. If your underlying is near your upside expiration on a butterfly trade, how would you reduce your delta risk with a synthetic position?

6. How can you completely neutralize a 100/110 call credit spread with puts?

7.  You are long a futures contract at $100.  The contract is now at $125.  How can you lock in the $25 profit without selling the futures contract over the weekend with a synthetic option position?

Good luck with the quiz!  I’ll post the answers next week.

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Why is AAPL becoming dangerous, and what to do?

The American past time used to be baseball. But the last couple years that has changed. The new American past time has become get long AAPL any way you can and wait for the profits to accumulate. Over the last 2 years, AAPL has gone from around 190 to 500, you figure the yields, staggering! Since June 20, AAPL has risen from 315 to the current level of 502, 60% in 8 months! Let me say that one more time, 60% in 8 months! So why shouldn’t it continue and why is it becoming dangerous? I’m glad you asked. Over the last 2 weeks, AAPL has shown a changed personality that you should be aware of. This personality is much different than the fun loving, get on my back , and I’ll take you up, up, to always higher stock prices. From a psychological perspective, this personality change started about 2 weeks ago around February 3. AAPL was trading at 460, and the March at-the-money implied volatility was around 19. What does that mean in English, Spanish, and Portuguese? It means everything was OK, and no real fear of the downside was propping up. But was it?  The speed to the upside was really picking up. From November 25 to February 3, AAPL went from 363 to 459, 26% in a little over 2 months. Everybody wanted in! On February 10th, AAPL hit 493 and March  at-the-money implied volatility in the calls spiked to 27. What’s the big deal? Option volatility usually decreases on the upside as prices go up and fear of the downside isn’t usually there. And remember, this is AAPL, this is America! But the last week, the personality disorder got much worse. As AAPL climbed a bit higher to 500, the March at-the-money option volatility climbed higher to 32 in the calls. That is an increase in 2 weeks from 19 implied volatility to 32 , an increase of 68% with the stock rising. Why are the option volatilities going up and what does it mean?  First of all why are the option volatilities going up?   SPEED!! Look at a pivotal day, Wednesday Feb 15, AAPL traded intra-day to 526 and closed at 497. That’s a decrease of 5% from the daily high to the close. The stocks rate of speed up and down intraday is really picking up in both directions. Sellers are coming in a bit!  The last time I really saw this kind of speed to the upside was the internet debacle many years ago when stocks were screaming to the upside, do you remember what happened after they went up very fast? What does increasing option volatility mean to the retail trader? It means the green light on the stock may possibly be turning to yellow and you should exercise a bit of caution. Does this volatility news mean I can’t stay bullish on my beloved AAPL?  No, it just means HOW you get long may need to change. This leads me to the strategy for today if I want to be long AAPL but be cautious!

Strategy idea: With this disturbingly changed personality in AAPL the last 2 weeks, I would approach any bullish trade very cautiously and make sure the risk/reward looks acceptable to me. In other words, if AAPL nosedives, I’m very comfortable with my total downside risk. I would initiate the below strategy after 1-2 down days.

Strategy example:  Stock at 502.5  Buy 1 March 500 call and sell 1 March  505 call for a debit of around $2.40 ( $240). This strategy called a vertical debit spread, allows you to play a high priced stock for a very reasonable cost. We are actually selling an option with more time premium than we are paying for with our long. This is good considering option volatilities called implied volatility have skyrocketed the last few weeks. The risk/ reward is about 1 :1 meaning we can make $250 profit potential with maximum risk of $250. If the stock is 505 or higher at expiration ( 2 ½ dollars higher than the current 502 level), I can make 100%. This again is a cheap way with limited downside risk ( $250) to play a very expensive and volatile stock.

Be careful and have a greatweek!  Dan Sheridan  dan@sheridanmentoring.com

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