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ABOUTTHEAUTHOR

Tony Saliba began trading in 1979 on CBOE as an independent market maker. He was
a member of the CBOE Board of Directors from 1987 to 1989. He was featured in Jack
Schwagers
Market Wizards
.
He has traded virtually all the products on CME and CBOT. He is the former CEO of
LiquidPoint, and was Executive Managing Director of BNY ConvergEx.
He currently sits on the Advisory Board of Efficient Capital Management, and has
authored several books on options trading. Today, he spends a great deal of his time
devoted to Saliba Ventures, his family office.

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Chapter2:OptionsEquivalency

"Thevalueinknowingsyntheticrelationshipsisprofound.Itcanhelpanytraderorassetmanagersee
thoughtheweedsandmakebetterdecisionswithclarity.
Knowledgeofsyntheticrelationshipsisadyingartofthenewworldtrader.Tonyalwaysemphasized
thepowerofstudyingoptionsyntheticsasawaytoseparateyourselffromthecrowd."Chris
Hausman
___________
Manyconsiderthestudyofputcallparityoroptionsyntheticsageneralwasteoftime,usefulonlyfor
marketmakersandperhapsrelevantforclassroomstudy.However,nothingcouldbefurtherfromthe
truth!Thestudy,understanding,andthestrategicapplicationofputcallparityandsynthetically
equivalentpositionscansavetheenduseragreatdealofmoneyovertime.Masteringtheconceptof
syntheticsallowstheoptiontradertotakeadvantageoftemporarymispricinginthemarketplace,
andtominimizeexecutionriskandslippagewhenenteringorexitingaposition.Additionallyand
perhapsmostimportantly,itwillhelpprovidethetraderwiththeconfidencerequiredtomake
marketsproperlyandefficiently.

WhySyntheticsMatter
PositionExit

Traderscanoftenfindthemselvesavictimoftheirownsuccess,aslongcallorlongput
positionsmoveinthemoney.Exitingatradewithasyntheticmaybeeasierandmore
profitableinthisinstance.

Marketmakerswidenthebidaskspreadofhighpriced,highdeltaoptionstocompensatefor
hedgingrisk.

Fundsandotherprofessionalsattemptingtoliquidateapositionwillsometimesgiveawaya
lotofextraprofit.

Bettertousethelowdelta,outofthemoneysideofthestrikewithanarrowbidaskspread
forexit.

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PositionEntry

Usingsyntheticrelationshipsthesmartoptionstraderhastwowaystoapproachadirectional
trade.

Jumpingtheunderlyingsideoftradefirstandaddingtheoptionsideofthetradesecond
enablestheendusertoavoidslippageonsignals.

Volatilityaroundsupportandresistancelevelscancreatetemporarymispricing.

Useofthelowdelta,outofthemoneysideofthestrikereducesdirectionalriskandslippage.

HedgingExistingPositions

Changethenatureofthepositionasmarketviewchanges.

Changelongpositionstolongcallsorshortputs.

Changeshortpositionstoshortcallsorlongputs.

Fullyhedgeusingcombos.

ChangelongorshortpositionsintotacticalspreadsusinglevelIIsynthetics(laterinthebook).

Drawbacks

Closingtradeswithasyntheticpositionwillleavearesidualarbitrageposition(conversion,
reversal).

Thispositionwillremainuntilexpiration.

Couldtieupcapital.

Couldresultinpinrisk.

DefinitionofPutCallParity

Putcallparityreferstotheconceptthatputoptionsandcalloptionsofthesamestrikeandsame
expirydateareessentiallythesameinstrument.Theonlydifferencebetweenaputoptiononan

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underlyingproduct,saywithastrikeof2000andexpiringinJune,andacalloptiononthesame
underlyingproductwiththesamestrikeandexpirationdate,isthattheputallowsitsowner
to
sell
theunderlyingwhereasthecallallowsitsownerto
buy
theunderlying.
Thedifferenceisactuallyfairlyinconsequential.Withasimplehedgeusingtheunderlying,acall
optioncanbetransformedintoasyntheticputoption.Andtheoppositeisalsotrue;aputoptioncan
behedgedwiththeunderlyingproducttobetransformedintoasyntheticcalloption.Thisisthe
essenceofputcallparity.Thebottomlineisputsandcallscanbecreatedtobethesamething.

Synthetics
Tounderstandputcallparity,itsimportanttofirstexplorethearithmeticconceptofsynthetics.
Optioncombinationscanbeusedtocreateequivalentriskreturnparametersassinglefuturesor
options.Thesearecalledsyntheticpositions.Wewillstartwiththemostbasicrelationshipthatwe
callsyntheticstockorsyntheticfuture.
Ifyouarelongacallandshortaputofthesamestrikeinthesameexpiration,youhavetheexact
sameprofitandlossgraphshapeasifyouarelongunderlying.Wecallthis(longcall/shortput)a
combo.

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Figure1
OptionsTechnologySolutions,UK

Ifyouthinkofthecomboequationasamathematicalequation,youcanrearrangethepiecesto
createothersyntheticpositions.So,thecomboequationof:

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Figure2
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Figure3
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Thesesyntheticrelationshipsarekeybuildingblockstounderstandingoptions.Throughthe
syntheticrelationship,youcanequatecallsandputs.Thatis,youcanthinkofcallsasputsandputsas
callsintermsoftheirriskprofiles.

Figure4
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Figure5
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Figure6
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Figure7
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Figure8
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Figure9
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Basis
ThenextbuildingblockinunderstandingPutCallParityiscalledbasis.First,whatisthedifference
betweenbuyingstockandbuyingsyntheticstock(buycallandshortput)?

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Thecarryisabenefittoowningsyntheticstockandadetrimenttoowningstock.Then,arethereany
benefitstoowningstockoversyntheticstock?
Yes.Ifyouownstock,youareentitledtoanydividendsthecompanypaysout.Ifyouownsynthetic
stock,youarenotentitledtothedividends.Thecombinationofthebenefitsanddetrimentsto
owningstockiscalledthebasis.Thebasisisdefinedas:

Thiscanbeusedtocalculatethefuturevalueofthestock.

Example:
XYZstockistradingfor$100.Thereare4dividendsthisyearof$0.75each.Theratechargedforlong
stockbyyourbrokeragefirmis4%.WhatisthefuturevalueofXYZsharesinoneyear?

Rememberingtheformulaforfuturestock:
StockFutureValue=StockPrice+CarryDividends

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PutcallparityquantifiestheproperrelationshipbetweenEuropeanstyleputsandcallstoprevent
arbitragebetweensyntheticandnaturalpositions(asinstockvs.syntheticstock.)Theformulais:

AlthoughtheconceptofputcallparityexistsinAmericanstyleoptions,itiscomplicatedbyearly
exerciseopportunitiesthatwillmodifytherelationship.
Example:
TheXYZNovember$65Callistradingfor$3.45andtheXYZNovember$65putistrading
for$2.10.Itscostofcarryis$0.23witha$0.10dividendbeforeexpiration.Wherethestockshould
betradingifputcallparityisachieved?

Thisisthesinglemostimportantfactorinunderstandingoptionsasunderstandingputcallparity
allowsyoutopriceoptionswithoutusingtheoreticalvaluemodels.Whenputcallparityisoutofline
arbitrageopportunitiesexist.

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Europeanvs.AmericanandPutCallParity
PutCallParityiseasiertounderstandwhenusingEuropeanStyleOptions.EarlyExercisepossibilityin
AmericanStyleoptionsmakesithardertodefine.

SyntheticsSimplified
Thissimplifiedequationletsyouderivethesixbasicsyntheticsrelationshipsveryquickly.Ifyou
rememberbasicalgebra,movingavariablefromonesideoftheequationtotheotherside,changes
itssign.

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