Hi Shoppers,

You know the marshmallow candy Peeps?

They’re the garishly colored, bird-shaped treats found in Easter baskets across the country. (Weirdly, no one I know actually likes them, but that’s neither here nor there.)

And the ingredients list is a real who’s who: sugar, corn syrup, gelatin, various food dyes and salt.

They all come together to form something different – namely a spongey fructose fowl.

But what does that have to do with trading?

Well, Peeps remind me a bit of synthetics options … which allow you to create a call, a put or a stock buy by combining the other two.

Let me explain …

Synthesize for Something New

When I was a market maker in the Cboe, we carried huge positions that were long and short options in every strike up and down the chain and in every month, along with a stock position.

 

The synthetics allowed us to pull out all the reversals and conversions – basically taking out all the neutral positions to see what was left. It helped us decipher what that massive position actually was and how it was going to move.

 

A quick note before we go any further:

 

• Reversal = short stock + long call + short put (neutral)
• Conversion = long stock + short call + long put (neutral)

 

Once we removed reversals and conversions we could see if we were long or short gamma, long or short vega, how many deltas we were long or short, etc.

 

This was (and remains) an essential tool to break down those huge positions.

 

So we would basically go through every strike (call and put) and pull out all reversals and conversions.

 

Back when, we literally did this by hand every day!

 

It also helped us to understand and really know what we were carrying and how we were going to go about trading that day.

 

Combine to Create

So options synthetics involve combining two of the three (calls, puts and stock) to synthetically create the third.

 

Having this list below committed to memory will help make you a better trader – so write these down! (Or put them in your Notes app – I live in the 21st century.)

 

Here we go …

 

• Long stock = long call + short put
• Short stock = short call + long put 
• Long put = long call + short stock

• Short put = short call + long stock
• Long call = long put + long stock
• Short call = short put + short stock 

 

If you know these synthetics, you will know your risk and can better manage your trades.

 

Before everything was computerized and electronically quoted, not everyone knew or used this essential tool, so we could find options completely out of whack which meant there was a lot of risk-free money to be had. 

 

The first market maker I clerked for back in 1986 was scooping a whole dollar on these essentially no-risk trades.

 

Talk about an Easter egg hunt. It was insane! 

 

But for your trading today – keep that list above handy and reap the benefits in your trading.

 

Oh, and one other note … unlike Peeps, synthetic options carry no risk of diabetes.

 

Thanks for Reading … See You Next Tuesday!

Licia Leslie