Using synthetics to minimize event risk

Much is made about making profits but protecting them is equally important, especially in these uncertain economic times. In that regard, I’ll be writing the occasional article on risk reduction strategies that will show you ways to protect existing positions as well as introducing some low-risk and even riskless trades.

To kick off this series, I’m devoting today’s blog to the discussion of how synthetics can reduce event risk. If you don’t know what any of this means, don’t worry for it will all be explained in due course.

What is a synthetic?
For any conceivable stock or options position there is an equivalent synthetic position that uses a combination of the underlying instrument plus call or put options to achieve an identical risk/reward profile. Although synthetic positions require at least two transactions (and hence two commissions as opposed to one) to set up, they are more versatile in terms of making trading adjustments than their underlying equivalent. With a combination of timing, trading skill, and perhaps a dose of luck, a seasoned options trader can potentially profit from both sides of the trade while still providing the benefits of lowered risk and, for the cases where the underlying is completely replaced by options, a lower entry cost.

Today we’ll be looking at one way you can protect an individual stock (or futures) position using synthetic calls and puts.

Synthetic calls
The synthetic call is used to protect long positions on optionable stocks and futures contracts. It is constructed by buying the stock and an equivalent number of at-the-money (ATM) put options. (Remember that 100 shares of stock = 1 options contract.) The synthetic call is just another name for a protective put. The risk/reward profile is identical to that of a long call. (Click here to see the profile of a synthetic call.)

Let’s look at a recent example of how using a synthetic call on the SPY would have worked just before the release of yesterday’s Consumer Confidence Index.

Suppose you’re bullish on the direction of the market and have been holding a long position in the SPY, the S&P 500 tracking stock. You knew the Consumer Confidence report would be released on Tuesday, May 26 at 10am ET and were (justifiably) concerned that a bad number could derail the market and wipe out your gains. What could you have done to ease your mind and protect your position?

Just ten to fifteen minutes before that number was to be released, you could have picked up the June 85 put for $2.85 to $2.95 per contract and sold them ten minutes after the release for $2.25. This put insurance would have cost you 65 to 75 cents per share, but it was more than covered by the corresponding gain in your SPY position ($1.12 – $1.46 during the 9:45am to 10:10am timeframe). Your net gain would have been in the 37 to 81 cents per share range—a pretty decent return in less than a half an hour! Of course, no profit is realized until the underlying stock is sold, but at least you were protected against potential damage had the number been bad.

And what if the Consumer Confidence number had been ugly? Had the market turned negative, your put would have become more valuable, offsetting the loss in your stock. In fact, the maximum loss you could ever incur with this strategy is limited to the price of the puts plus commission costs whereas your maximum loss without put protection is equal to your entire initial investment. I’d say that’s worth it.

When to initiate put protection
The above example shows how the synthetic call would have worked for a key economic event. Other events where this strategy makes sense is on a stock where a negative or an even less than stellar earnings report could push it over a cliff (think Apple (AAPL) or Google (GOOG)). Also, drug companies with key drugs nearing the end of a study phase also make good protective put candidates especially small biotechs with only one or two drugs under development.

I could have used protective puts in two stocks in my M&A portfolio. When vacation timeshare company Bluegreen (BXG) announced that the company seeking to acquire it needed more time to do their due diligence, that was when the alarms went off and  I should have bought a protective put. It sure would have saved me from a 53% loss I finally had to swallow!  The other position I should have protected was Rohm-Haas (ROH). When acquiring company Dow Chemical (DOW) announced that it was having financing difficulties was the time to protect the position. (As it turned out Dow made good on the deal and I was spared another humiliating loss, but it came at the expense of a lot of mental anguish.)

What type of protection to buy
Now that you know when to buy protection, what strike and expiration should you go for? If you’re looking only for very short term protection like in the above example, buy the front-month option with the requirement that you won’t be holding it for more than a couple of days, max. The reason for a short holding time is that options begin rapidly losing time value about 30 to 45 days before expiration. On the other hand, if your underlying stock is highly volatile and you think there’s a good chance you could profit from an increase in the price of the option, then I’d purchase one with an expiration date at least three months in the future.  This gives you more time without having to worry about time decay eating away at the value of your option, but it probably won’t do much to help you with the issue of decreasing volatility which also affects options pricing.  An option can lose value even if the stock does nothing because of a decrease in volatility, so keep that in mind, too, especially since the volatility of the overall market has been declining.  

As for the strike price, it depends on how much insurance you want and what you paid for the underlying. If your stock has increased in price, you could purchase a put with a strike near the initial cost. The lower strike option will be cheaper but now you risk losing all of your current profit. In buying insurance, there’s always a tradeoff between cost and risk. The choice is up to you.

Synthetic puts
The synthetic put can be used in a similar fashion to protect short positions. In this strategy, you would buy the equivalent number of call contracts to balance your short position. Here, the risk/reward profile is the same as for a put option. Your maximum loss is limited to the price of the call plus commissions whereas the maximum loss of a short position is theoretically unlimited. It’s for this very reason that synthetic puts are a good idea, especially in these volatile markets.

We’ve seen that event risk can be mitigated by the judicious application of options. As with any options strategy, please paper-trade it first before putting on real money.

Here’s to a more restful night’s sleep!

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