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ABOUTTHEAUTHOR

ABOUTTHEAUTHOR Tony Saliba began trading in 1979 on CBOE as an independent market maker. He was

Tony Saliba began trading in 1979 on CBOE as an independent market maker. He was a member of the CBOE Board of Directors from 1987 to 1989. He was featured in Jack Schwager’s Market Wizards.

He has traded virtually all the products on CME and CBOT. He is the former CEO of LiquidPoint, and was Executive Managing Director of BNY ConvergEx.

He currently sits on the Advisory Board of Efficient Capital Management, and has authored several books on options trading. Today, he spends a great deal of his time devoted to Saliba Ventures, his family office.

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"Thevalueinknowingsyntheticrelationshipsisprofound. Itcanhelpanytraderorassetmanagersee thoughtheweedsandmakebetterdecisionswithclarity.

Knowledgeofsyntheticrelationshipsisadyingartofthenew­worldtrader. Tonyalwaysemphasized thepowerofstudyingoptionsyntheticsasawaytoseparateyourselffromthecrowd."­Chris Hausman

Manyconsiderthestudyofput­callparityoroptionsyntheticsageneralwasteoftime,usefulonlyfor

marketmakersandperhapsrelevantforclassroomstudy.However,nothingcouldbefurtherfromthe

truth!Thestudy,understanding,andthestrategicapplicationofput­callparityandsynthetically

equivalentpositionscansavetheend­useragreatdealofmoneyovertime.Masteringtheconceptof

syntheticsallowstheoptiontradertotakeadvantageoftemporarymispricinginthemarketplace,

andtominimizeexecutionriskandslippagewhenenteringorexitingaposition.Additionallyand

perhapsmostimportantly,itwillhelpprovidethetraderwiththeconfidencerequiredtomake

marketsproperlyandefficiently.

PositionExit

WhySyntheticsMatter

Traderscanoftenfindthemselvesavictimoftheirownsuccess,aslongcallorlongput positionsmovein­the­money. Exitingatradewithasyntheticmaybeeasierandmore profitableinthisinstance.

Marketmakerswidenthebid­askspreadofhighpriced,highdeltaoptionstocompensatefor

hedgingrisk.

Fundsandotherprofessionalsattemptingtoliquidateapositionwillsometimesgiveawaya

lotofextraprofit.

Bettertousethelowdelta,out­of­the­moneysideofthestrikewithanarrowbid­askspread

forexit.

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PositionEntry

Usingsyntheticrelationshipsthesmartoptionstraderhastwowaystoapproachadirectional

trade.

“Jumping”theunderlyingsideoftradefirstandaddingtheoptionsideofthetradesecond

enablestheend­usertoavoidslippageonsignals.

Volatilityaroundsupportandresistancelevelscancreatetemporarymispricing.

Useofthelowdelta,out­of­the­moneysideofthestrikereducesdirectionalriskandslippage.

HedgingExistingPositions

Changethenatureofthepositionasmarketviewchanges.

Changelongpositionstolongcallsorshortputs.

Changeshortpositionstoshortcallsorlongputs.

Fullyhedgeusingcombos.

ChangelongorshortpositionsintotacticalspreadsusinglevelIIsynthetics(laterinthebook).

Drawbacks

Closingtradeswithasyntheticpositionwillleavearesidualarbitrageposition(conversion,

reversal).

Thispositionwillremainuntilexpiration.

Couldtieupcapital.

Couldresultinpinrisk.

DefinitionofPut­CallParity

Put­callparityreferstotheconceptthatputoptionsandcalloptionsofthesamestrikeandsame

expirydateareessentiallythesameinstrument.Theonlydifferencebetweenaputoptiononan

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underlyingproduct,saywithastrikeof2000andexpiringinJune,andacalloptiononthesame

underlyingproductwiththesamestrikeandexpirationdate,isthattheputallowsitsowner

toselltheunderlyingwhereasthecallallowsitsownertobuytheunderlying.

Thedifferenceisactuallyfairlyinconsequential.Withasimplehedgeusingtheunderlying,acall

optioncanbetransformedintoasyntheticputoption.Andtheoppositeisalsotrue;aputoptioncan

behedgedwiththeunderlyingproducttobetransformedintoasyntheticcalloption.Thisisthe

essenceofput­callparity.Thebottomlineisputsandcallscanbecreatedtobethesamething.

Synthetics

Tounderstandput­callparity,it’simportanttofirstexplorethearithmeticconceptofsynthetics. Optioncombinationscanbeusedtocreateequivalentrisk­returnparametersassinglefuturesor options. Thesearecalled“syntheticpositions”. Wewillstartwiththemostbasicrelationshipthatwe call“syntheticstock”or“syntheticfuture.”

Ifyouarelongacallandshortaputofthesamestrikeinthesameexpiration,youhavetheexact sameprofitandlossgraphshapeasifyouarelongunderlying. Wecallthis(longcall/shortput)a “combo.”

Wecallthis(longcall/shortput)a “combo.” 6 ©2016OptionTechnologySolutions,LLC.AllRightsReserved.

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Figure1 ​ OptionsTechnologySolutions,UK Ifyouthinkofthecomboequationasamathematicalequation,youcanrearrangethepiecesto

Figure1

OptionsTechnologySolutions,UK

Ifyouthinkofthecomboequationasamathematicalequation,youcanrearrangethepiecesto

createothersyntheticpositions.So,thecomboequationof:

createothersyntheticpositions.So,thecomboequationof: 7 ©2016OptionTechnologySolutions,LLC.AllRightsReserved.

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Figure2 ​ OptionsTechnologySolutions,UK Figure3 ​ OptionsTechnologySolutions,UK 8

Figure2

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Figure2 ​ OptionsTechnologySolutions,UK Figure3 ​ OptionsTechnologySolutions,UK 8

Figure3

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Thesesyntheticrelationshipsarekeybuildingblockstounderstandingoptions. Throughthe syntheticrelationship,youcanequatecallsandputs. Thatis,youcanthinkofcallsasputsandputsas callsintermsoftheirriskprofiles.

callsintermsoftheirriskprofiles. Figure4 ​ OptionsTechnologySolutions,UK Figure5 ​

Figure4

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Figure4 ​ OptionsTechnologySolutions,UK Figure5 ​ OptionsTechnologySolutions,UK 9

Figure5

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Figure6 ​ OptionsTechnologySolutions,UK 10 ©2016OptionTechnologySolutions,LLC.AllRightsReserved.

Figure6

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Figure7 ​ OptionsTechnologySolutions,UK Figure8 ​ OptionsTechnologySolutions,UK 11

Figure7

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Figure7 ​ OptionsTechnologySolutions,UK Figure8 ​ OptionsTechnologySolutions,UK 11

Figure8

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Figure9 ​ Basis OptionsTechnologySolutions,UK ThenextbuildingblockinunderstandingPut­CallParityiscalled“basis.”

Figure9

Basis

OptionsTechnologySolutions,UK

ThenextbuildingblockinunderstandingPut­CallParityiscalled“basis.” First,whatisthedifference betweenbuyingstockandbuyingsyntheticstock(buycallandshortput)?

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Thecarryisabenefittoowningsyntheticstockandadetrimenttoowningstock. Then,arethereany benefitstoowningstockoversyntheticstock?

Yes. Ifyouownstock,youareentitledtoanydividendsthecompanypaysout. Ifyouownsynthetic stock,youarenotentitledtothedividends.Thecombinationofthebenefitsanddetrimentsto owningstockiscalledthe“basis.” Thebasisisdefinedas:

owningstockiscalledthe“basis.” Thebasisisdefinedas: Thiscanbeusedtocalculatethefuturevalueofthestock. Example:

Thiscanbeusedtocalculatethefuturevalueofthestock.

Thiscanbeusedtocalculatethefuturevalueofthestock. Example: XYZstockistradingfor$100.

Example:

XYZstockistradingfor$100. Thereare4dividendsthisyearof$0.75each. Theratechargedforlong stockbyyourbrokeragefirmis4%. WhatisthefuturevalueofXYZsharesinoneyear?

Rememberingtheformulaforfuturestock:StockFutureValue=StockPrice+Carry–Dividends

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Put­callparityquantifiestheproperrelationshipbetweenEuropean­styleputsandcallstoprevent

Put­callparityquantifiestheproperrelationshipbetweenEuropean­styleputsandcallstoprevent arbitragebetweensyntheticand“natural”positions(asinstockvs.syntheticstock.) Theformulais:

Theformulais:

Althoughtheconceptofput­callparityexistsinAmerican­styleoptions,itiscomplicatedbyearly

exerciseopportunitiesthatwillmodifytherelationship.

Example:TheXYZNovember$65Callistradingfor$3.45andtheXYZNovember$65putistrading

for$2.10. Itscostofcarryis$0.23witha$0.10dividendbeforeexpiration. Wherethestockshould betradingifput­callparityisachieved?

Wherethestockshould betradingifput­callparityisachieved?

Thisisthesinglemostimportantfactorinunderstandingoptionsasunderstandingput­callparity

allowsyoutopriceoptionswithoutusingtheoreticalvaluemodels.Whenput­callparityisoutofline

arbitrageopportunitiesexist.

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Europeanvs.AmericanandPut­CallParity

PutCallParityiseasiertounderstandwhenusingEuropeanStyleOptions.EarlyExercisepossibilityin

AmericanStyleoptionsmakesithardertodefine.

AmericanStyleoptionsmakesithardertodefine. SyntheticsSimplified

SyntheticsSimplified

Thissimplifiedequationletsyouderivethesixbasicsyntheticsrelationshipsveryquickly.Ifyou

rememberbasicalgebra,movingavariablefromonesideoftheequationtotheotherside,changes

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