- 1999: Volume 8, No. 5 Puts & Calls: It's Synthetic, But Produces Real Results

Stock trading's fun, isn't it? Especially if your idea of a good time involves dating anybody with the last name "dot com." Investors' desire to trade these stocks is often tempered with fear of persistent market volatility. A constant refrain heard on call-in programs, chat rooms and at roller rink 10 cent beer nights is, "How do I stay in the market without losing my shirt?"

It's lucky for these folks that options were invented. Before the advent of listed options trading, nervous investors had but two choices: sell out their stock, foregoing upside potential or hold stock naked with the hope that any forthcoming decline was minor and temporary.

With options, however, investors can more readily hold shares through periods of expected volatility. As most people who have looked into option trading probably have found, the basic building block of an option hedge is a put purchase. Suppose, for example, you'd recently bought 1,000 shares of XYZ at 50. You may think that there's huge upside potential long-term, but may still be nervous about the near-term effect of industry earnings reports on the stock.

You decide to buy ten five-month XYZ 50 puts at "four" as a hedge. Combining the put purchases with your stock holdings gives you this expiration exposure:

Long Stock		Long Stock + Long Put
Unlimited (above breakeaven)	Maximum Gain	Unlimited (above breakeven)
Stock Cost (50)	Breakeven	Stock Cost + premium [54]
Stock Cost (50)	Maximum Loss	(Strike Price - stock cost) + premium [4]

Net result? As you can see, adding the protective put allows you to swap the open-ended loss potential of the stock position for a much smaller risk, while still preserving the stock's unlimited upside potential. But you knew that, right?

HmmmÉ unlimited upside potential and strictly limited loss potential in a falling market. Sounds like the risk/reward characteristics of call ownership, doesn't it? That's exactly why the put-protected stock position is known as a "synthetic long call." The combined position behaves like a purchased call but there ain't a call in it. And the cost of this call? Simply put, it's the reduction in your stock's upside represented by the put "insurance" premium.

Another position often employed by stock investors is "overwriting." Investors gain some downside protection simply by writing calls on stock held in their portfolio. You might, for example, decide that the anticipated sell-off will be limited to a relatively narrow range. You note that you can sell ten five-month XYZ 50 calls at five. By writing these calls on your stock, you'd change the expiration risk/ reward characteristics like this:

Long Stock		Long Stock + Long Call
Unlimited (above breakeaven)	Maximum Gain	(Strike price + premium) - stock cost [5]
Stock Cost (50)	Breakeven	Stock cost - premium [45]
Stock Cost (50)	Maximum Loss	Stock cost - premium [45]

Plainly, overwriting cuts short your stock's upside in any potential rally. The trade-off? Receipt of call premium has improved your breakeven point. Below your now-adjusted breakeven point, however, there's still open-ended risk. But you knew that too, didn't you?

Now ask yourself what kind of option position exposes a trader to open-ended risk in a falling market, and limits profit potential in rising market? If you thought of a short put, you're right on the money. In fact, a covered call is the synthetic equivalent of a written put.

So let's re-cap what we know. Protective puts cost premium. Overwriting earns premium. Care to figure out the math? What if we buy the protection we want from the puts, but use the call sale as the financing mechanism? If we used the 50 calls and puts, we'd earn a net credit of a point just by putting on the hedge. That would be the five points earned from the call sale, less the four point expense for purchasing the puts. Sounds like the best of all worlds, doesn't it? Hedge your downside and get paid for it! But there is a catch: you've hedged away your upside. The best that this position could do, if held in toto through expiration, is to earn the net credit. The reason? Combining the short call together with a long put creates yet another synthetic: short stock. It's like going "short against the box"-you've got long stock in one account and short stock in another. The positions eventually offset one another.

Eventually, you say?

Because we're using options here, time value has to be taken into account. Time value decay is a benefit for a short option, but a detriment for long option. At expiration, of course, all the time value's used up. At that point, options are worth only intrinsic values. Our position's expiration scenario looks like Figure 1.

Figure 1

This position is a classic hedge. As can be seen, the status quo is locked in. But before expiration, while time value's still extant, the pay-out diagram looks decidedly different. Figure 2 illustrates the potential payouts a month, two months, and three months away from expiration. (Chart values are based upon a constant 35 percent volatility, $0 dividends, and a five percent risk-free interest rate.) Now, what does this chart tell us? Just this-while the hedge is on, if there has to be stock volatility, the later the better. That is, as long as the hedge hasn't expired.

Figure 2

But remember, the hedge is supposed to be temporary. Once, and if, the danger passes, the hedge can be lifted, leaving you with naked long stock. At that point you would again have open-ended profit potential.

Our example used calls and puts struck at the same price. In actual practice, however, it's far more common to see a split-strike hedge. Suppose, for instance, you were to use out-of-the-money options to hedge stock's current $50 price level:

Long 10 5-month 45 XYZ calls @ 1 3/4 Short 10 5-month 60 XYZ puts @ 1 1/2
Net debit	- 1/4

Payouts at expiry, one, two and three months out from expiration are illustrated in Figure 3. (Again, chart values are based upon a constant 35 percent volatility, $0 dividends, and a five percent risk-free interest rate.) Using out-of-the-money calls opens up more upside potential, while the out-of-the-money puts create more potential downside risk. In sum, more allowance is given for market volatility before the hedge effect kicks in. Most notable, however, is the effective "fence" created by the strike prices. Profits are capped when the stock moves above the call strike, while losses are limited to the levels engendered at the put strike price level. It's as if the strike prices form a collar around the position's profits and losses. That's why the position's commonly called a "collar" or "fence." Take notice of the time decay at work here. The collar tightens as time passes and expiry approaches. Given this, you'll magnify your hedge effect when using shorter-term options in the collar.

Figure 3

Collars are created by the overlay of synthetic short stock on an existing portfolio position. The synthetic short call is itself a combination of a synthetic short put and a synthetic long call.

Confusing? It needn't be. We'll take a look at more synthetics in a future installment.

Brad Zigler is Managing Director, Options Marketing, Research & Education at the Pacific Exchange in San Francisco. He can be reached through the Exchange's web site at www.pacificex.com. Send e-mail to: bzigler@pacificex.com. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. The examples presented do not take into consideration commissions, tax considerations or other transaction costs, which may significantly affect the economic consequences of a given strategy. Options involve risk and are not for everyone.