Synthetics in a Low Volatility Environment

In a low volatility environment, creating synthetic call and put positions offers traders creative flexibility. Synthetic positions can allow traders a position in the underlying stock (long or short) with protection.  Synthetic long calls or puts afford traders the luxury of cheap protection while creating unlimited upside potential on calls: with the only limitation to the downside for puts is the zero mark.

A synthetic call is created when the trader buys stock and purchases a put contract for downside protection (the position can also be legged). A synthetic put is created by selling shares of stock while simultaneously purchasing a call for protection. Since the spread consists of two separate legs, the protective options can be purchased at any time the trader is either long or short shares of stock. It is most conservative to always have the protection—the long option—in place. Simply put, naked short stock has unlimited risk and in an atmosphere where we have seen stocks like Google and Amazon soar over a hundred points within days or even hours; having the protective option in place curtails potential sizable losses.

That said, there are added benefits to using options to create synthetic positions especially in a low volatility environment. Premiums are historically low in many high quality stocks. With the markets near all-time highs, shorting stocks and buying calls to create a synthetic put can in some cases be done at very low cost. The low volatility allows traders to buy the calls closer to the stock price, which increases or triggers downside profits as the call goes out of the money (OTM) quicker as the stock drops. The same holds true for synthetic calls, which comes with the added benefit of owning stock if there is a dividend involved. Several examples over the years can be back tested with recent examples involving Google & Amazon which both ran over one hundred points in a two week period this past July. There are many examples that show a synthetic long call can potentially beat owning the stock outright.

When the stock market crashed in 1987, Chrysler saw its volatility go from an average of between 28 – 33 to topping out around the 120 level in a matter of days and it continued to stay that high for months. Many stocks suffered the same fate such as IBM which dropped from a high of over $225 before eventually bottoming around the $50 level. Additionally, when the markets become more volatile, premiums increase. This creates a window of opportunity for unwinding the position at a higher volatility. The window of opportunity though has waned due to the fact that many traders now sell spikes in volatility as their programs dictate. Thus, traders should create the synthetic position while volatility is low, and option prices are cheap, and not wait until after the stock moves, when it is too late.

Remember, as in life, timing is everything. In a low volatility environment, creating synthetic call and put positions offers the trader the luxury of cheap protection while creating unlimited upside potential on calls and basically unlimited protection to the downside for puts to the zero mark. Taking advantage of low volatility at opportune times like earnings announcements and extreme moves like this current volatile market can offer can offer both protection and an excellent risk/reward profile.

Ross Barnett Terry
Capital Wealth Planning, LLC
Covered Call Strategists
Illinois Indiana Regional BDO

Trader Education