Option Trading Blog

This is the second part of the option trading with synthetic positions. If you haven’t read it, please read it now. In this post, i’ll discuss the common risks in taking such synthetic positions so you would know what to avoid.

Consider the following example: A stock trading at 103, a 100 call option with 1 month to expiration trading at 6$, and 1 month 100 put, trading at 3$. As we have learned in the last post, it looks like no arbitrage profit is possible since:

• call price - put price = stock price - exercise price
• 6-3 = 103-100

Suppose we want to purchase the stock and sell the synthetic difference. This means we buy the stock for 103$, sell the call for 6$, and buy the put for 3$. This will create a total debit of 100. This debit will be carried to expiration when we either exercise (sell) the stock for 100$ through the put or through the call. Since in the real world, interest rates are not zero, there is a cost to carrying a debit. Suppose the 1 month interest rate is 1%. According to the synthetic relationship, we are supposed to break even. What happens in the real world? we would lose $. Hence, our synthetic assumption needs to be adjusted to the interest rate.

• call price - put price = stock price - expiration price + carrying cost

Suppose the call is traded for 5$, the put for 3$ and the stock is worth 101$. This would mean we are balanced since

• 5 - 3 = 101 - 100 + 1

Where we have used a 1% interest rate on the exercise price.

The case of dividends

Suppose that prior to expiration, we receive a dividend of 1.5$. When we have purchased the stock, we would have received another 1.5$. Hence, we can afford to “lose” 1.5$ more and still break even. The put-call parity has to be adjusted for dividends.

• call price - put price = stock price - exercise price + carrying costs - dividends

Arbitrage Risk

If you are new to trading, the synthetic option trading looks very lucrative. There are a number of risks involved to this though that you should be aware of.

Interest rate risk

Notice that we assumed that we know what would be the interest rate for the period of the trade until expiration. What happens if the interest rate changes? You are at risk on losing profit. This means you should be careful when executing the strategy for longer periods of time where there is uncertainty about the interest rate.

Problems with executing the trade

On paper, it is easy to spot the arbitrage opportunities. The problems arise when you want to execute the trade and the price you are given is not the price you had thought you would receive. There may be liquidity issues that might cause you not to finish all the trade. You might be able to sell the put and buy the call, but have problems buying the stock at the price you wanted.

Dividend Risks

The amount of dividend given to stock owners can change and hence hurt your profits.