In the last posts, I was writing about synthetic positions and how to make profit out of them. We have seen though that they entail risk of interest rates and dividend payouts. How can we eliminate the need to buy (or sell) the stock itself?
Consider buying the following portfolio as we have discussed in the last series of posts:
- short a call
- long a put
- long a stock
How can we eliminate the risk involved with buying the stock? If the deeply in-the-money call has a delta of 100, it therefore acts like the stock. This means we can replace the stock and buy the following portfolio instead:
- short a call
- long a put
- long a deeply in-the-money call
The Box Technique
In the spirit of replacing the stock by another combination of options, consider the following portfolio:
- short a 1 month 100 call
- long a 1 month 100 put
- long a stock
Is there another way to replace the stock? Suppose we also buy the following contract:
- long a 1 month 90 call
- short a 1 month 90 put
- short a stock
The long and short stocks cancel each other out, leaving us with a combination of options alone. We are only left with a synthetic long at 90 exercise price and a synthetic short at 100 exercise price. This portfolio is known as a box. At expiration, we sell the stock for 100$ and sell it for 90$ for a profit of 10$. This means it must be worth the value of the box at expiration minus the costs of interest:
This as always can work the other way around. I didn’t have time to put here some numerical real life examples, I’ll do that in the next post and I’ll also add another strategy to reduce the risk in a synthetic position
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Hi, enjoyed the blog. Thanks.