Hi Shoppers,

As a growing trading education firm, a healthy portion of our clients here at Option Pit are fairly new to trading options.

So for you newbies, here is a lesson on options synthetics.

First some quick history.

Options on equities were created by Chicago Board of Trade (CBOT) commodities futures traders. 

The Chicago Board Options Exchange (Cboe) opened on April 26, 1973, the 125th birthday of the CBOT, and only listed call options … puts wouldn’t arrive until four years later.

Can you imagine trading calls without puts?!

If you understand options synthetics, you know exactly what I mean. (More on those in a second.)

Options were created as insurance against stock positions.

You can literally create long and short stock positions using calls and puts … they are an incredible way to make money off market swings while managing risk.

As an options trader you need to know your synthetics, which involves combining two of the three (calls, puts, and stock) to synthetically create the third.

Committing these to memory will help make you a better trader.

Here we go …

Long call + short put = long stock

Short call + long put = short stock

Now, I am going to stop for a second for a bit more history and a key point about volatility.

In the past, knowing those first two bullet points, along with the dividend and interest, allowed traders to spot mispriced options.

It doesn’t happen anymore because everything is electronically quoted.

But before that, the market maker I clerked for back in 1986, was able to scoop a whole dollar on these essentially no-risk trades.

It was insane!

That is why volatility (price fluctuation) is important now … everything is properly “theoretically” priced by the computers.

Volatility is the key to finding strategic money making positions in options.

Back to synthetics:

Long call + short stock = long put

Short call + long stock = short put

Long put + long stock = long call

Short put + short stock = short call

My advice to traders of all levels is to memorize these six bullets.

As long as you know these relationships, you will know your risk and can better manage your trades. 

Thanks for reading … See You Next Tuesday,

Licia Leslie