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April 3, 2012

Option Synthetics Quiz Answers

Quiz Answer

Quiz Answer

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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Tom Nunamaker

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